Category: SA Economy

The balance of SA foreign trade turned into a very welcome surplus of about R5bn in May 2015. It apparently took the market by surprise, though it should not have, since the National Association of Automobile Manufacturers (Naamsa) had previously reported over 33 000 vehicles exported that month, more than enough to turn the trade flows.

Further good news came from Naamsa yesterday that reported 31 422 vehicles exported in June, another very good month for the motor manufacturing sector, the largest component of manufacturing generally, and the balance of payments. Export volumes of over 30 000 units now compare very well, with a satisfactory 50 251 units sold in the local market. Domestic sales numbered 47 868 units in May and June sales were about 1000 units higher, on a seasonally adjusted basis. However, as we show below, the vehicle cycle is clearly pointing to lower sales to come, with annual sales precited to fall from the current rate of 612 000 units to an annual rate of 523 000 units in June 2016.

This makes sustaining exports even more important for the industry and its dependents. The limits to exports are set by the willingness of the workers and their unions to stay on the job. The ability of the local industry to sustain its role in the global vehicle supply chain will depend on offering security of supply over the long run. The role of the unions in offering predictability of supplies from SA plants is clearly crucial. It is surely possible for the owners and the unions to come to terms on exchanging better paid jobs for reliability of attendance at work. Inevitably though, fewer person hours will be employed per vehicle produced as robots are substituted for more expensive labour, as is the case in manufacturing plants everywhere.

Yet if export volumes can be enhanced it may be possible to hire more rather than fewer workers – at better wages – even if the on average more expensively hired worker is made more productive with the aid of computer-driven equipment. The motor industry and the SA economy – in the form perhaps of a stronger rand – has much to gain from an infusion of self interested economic reality into collective bargaining. The reality is that it may be possible to provide well paid employment for a larger work force in some industries, if the opportunity to increase output for foreign markets can be taken. The highly competitive current rand exchange rate should encourage these negotiations. A better trade balance may well in turn help sustain the exchange value of the rand, which in turn would be very encouraging to domestic consumers. Additional demands from the households are even more essential to lifting SA GDP growth than are exports.

The course of the SA economy at the end of May 2015 appears largely unchanged since February. This is judged by the pace of new vehicle sales and demands for cash (adjusted for inflation) in May.

These two hard numbers, which are not dependent on surveys based on selected samples – released very soon after the economic events themselves – serve to make up our Hard Number Indicator (HNI) of the immediate state of the SA economy.

The HNI may be compared to the Reserve Bank’s Coinciding business cycle indicator, updated only to February 2015. Current readings well above 100 (2010=100) indicate that the economy has moved ahead at a more or less constant modest forward speed, and is forecast to continue to maintain this pace over the next 12 months. This impression is supported by comparison with the very similar readings taken a month before. The recent inflexion of the HNI is also supported by the Reserve Bank Indicator that has continued to point higher, at least until February 2015 the latest observation.

Unit vehicle sales, after a strong start to the year, however fell back in May 2015, especially when viewed on a seasonally adjusted basis. The trend in new vehicle sales on the local market is now pointing lower towards a pace of 45 000 units per month or an annual market of about 540 000 units in 12 months’ time.

The consolation for the automobile manufacturers and their suppliers in South Africa, the largest component of domestic manufacturing activity, facing a likely decline in sales volumes, is that exports in May rose very strongly to 33 411 units, enough to maintain very high volumes of overall activity in this important sector of the economy. Hopefully the unions will also recognise the long term benefits to them of sustained production and the export contracts that will flow from the SA plants being regarded as reliable partners in global manufacture.

A lower underlying trend in the headline inflation rate has helped support the growth in the demand for and supply of cash. But this favourable trend appears likely to be reversed in the months ahead, according to our time series based forecast. The prediction of higher inflation to come in the months ahead would be well supported by other forecasts, including those made with the Reserve Bank forecasting model. This model predicts that headline inflation, off its low base of early 2015, will breach the 6% upper band of its inflation targets in early 2016 but fall back within it later in the year.

There might be some relief that the SA economy has not slowed down faster in 2015 and has been able to sustain a modest rate of growth, equivalent to GDP growth of about 2% a year. The biggest threat to sustaining a mere 2% a year growth in output would be higher inflation itself- particularly the sort of inflation that has been inflicting the SA economy in the form of higher taxes and higher electricity prices (taxes by another name), as well as poorer harvests that push maize and food prices in SA higher. Higher prices forced by the supply side of the economy, extract from the purchasing power of households and depress the real incomes of households and the volume of spending they wish to undertake, which constitutes such a large component of total spending (over 60% of the total of spending). Without a recovery in household spending growth the economy will not grow faster than it is now doing. Businesses will only wish to add significantly more to their capacity in response to stronger demands from their ultimate customers, the household spender.

A weaker rand imposes the same risk of higher prices to come and would act as a further drain on household spending power and propensities. In the 12 months to date the rand has held its trade weighted value rather well (despite the stronger dollar) and could not be regarded as contributing to higher inflation to come. Without higher excise tax rates, on what is now a lower rand price for oil compared to a year ago, the inflation rate would have been significantly lower and so would have eliminated, at least for now, any argument for higher interest rates, given the state of demand.

The further and imminent danger to the growth prospects of the economy is the pronounced intention of the Reserve Bank to raise interest rates, apparently regardless of the state of the economy or the unpredictability of the impact of higher short rates on the exchange value of the rand and inflation. The hope for the SA economy and for a firmer rand must be an improved outlook for the global economy and especially emerging market economies that encourage flows of funds to emerging market equities and bonds that will support emerging market currencies. A stronger, not weaker, rand might then accompany a gradual normalization of global growth and global interest rates.

Until then emerging market central banks, including the SA Reserve Bank, would be wise to do nothing to harm their own growth prospects with tighter monetary policies in response to a gradual normalisation of interest rates in the developed world. The tool to help their economies adjust to possible volatility in global capital markets should be exchange rate flexibility, not higher interest rates.

Updating the state of the SA economy to February 2015 with our Hard Number Index (HNI). Economic activity continues to show slow and steady growth, with no obvious speed wobble.

The two very up to date hard numbers, unit vehicle sales in SA and the value of notes in circulation, have been released for February 2015. We deflate the money series with the CPI and seasonally adjust, smooth and extrapolate both series using a time series forecasting method. Both series continue to point higher, with unit vehicle sales continuing their recovery from the blip in early 2014.

It should be recognised that new unit vehicle deliveries to the SA buyer have maintained a robust pace, comparable with peak sales of 2006-07. Much improved exports of built up vehicles have also been helpful lately to the motor assemblers and their component suppliers, who account for the largest share of all manufacturing activity. The money base, adjusted for the CPI, had declined in 2008-09 but the demand for and supply of real cash has grown consistently since in line with economic growth generally.

When both series are converted into annual growth rates, it shows that the growth cycle remains in a recovery phase but that the current growth rates are predicted to slow down in 2015. Vehicle sales may be regarded as a very good proxy for capital expenditure undertaken by households and firms, while the demand for cash supplied by the Reserve Bank on demands for notes from the banks that are having to meet their customers’ demands for cash on hand rather than a deposit in the bank. These demands reveal spending intentions by households and may be regarded as a good coinciding indicator of spending decisions.

We combine these two hard numbers, vehicle sales and notes in circulation to establish our Hard Number Index of Economic Activity in SA (HNI). As we show below, the HNI for February 2015 has held its level and is forecast to continue to do so over the next 12 months. In other words, the growth in economic activity in SA is modestly positive but is not expected to gain or lose forward momentum. The HNI may be compared in this figure to the Coincident Business Cycle Indicator of the SA Reserve Bank that was still rising in November 2014, the latest month measured. We show in the further figure that the rate of change of the HNI, what may be regarded as the second derivative of the business cycle, that the rate of change of economic activity is predicted to remain barely in positive territory. That is to say, more of the same slow growth in economic activity in SA should be expected. The catalyst that would stimulate a stronger upswing in the business cycle remains very hard to identify.

The demand for and supply of cash in the economy has proved very helpful in predicting the state of economic activity in SA over many years. We include cash in our HNI for this reason and also because data on cash in circulation is so up to date and turns what may be coincident economic action, spending and cash determined simultaneously, into a leading indicator.

It may be of interest to recognise that despite all the innovations banks have made in the electronic transfers of deposits and encouraging the use of these convenient means of payment, the importance of the ratio of cash in the economy has not declined over the years. As we show below, the cash intensity of the economy (compared to estimated retail trade volumes) appears to have risen steadily between 1980 and 2000. It then stabilised at a higher level: it declined until 2010 and now appears to be rising again.

Part of the decline in demands for notes after 2003 was from the deposit taking banks themselves. The retail banks reduced their own demands for notes when the Reserve Bank stopped accepting notes in the bank tills and ATMs as part of required cash reserves. Only reserves held as deposits with the Reserve Bank qualified thereafter. But while this influence on the demand for cash seems to have worked its way through the system in the form of a decline in the cash to retail ratio, the ratio of cash to economic activity (represented here by officially measured retail volumes) seems inexplicably high. It does suggest that the statisticians may well be underestimating retail volumes and economic activity conducted informally. The informal economy has a much higher propensity to use cash rather than electronics to close deals. Hence the particular usefulness of cash as a leading indicator because it incorporates informal unrecorded economic activity that may well contribute significantly more to the economy than is officially recognised.

Only a narrower interest rate spread in favour of the dollar – which widened this morning.

The ECB initiated its bond buying (QE) programme yesterday. By this morning the German 10 year Bund yields had fallen back by about 7bp to 0.3101% p.a. The 10 year US Treasury Bond yields had also declined by about 4bp to 2.19% p.a. Hence the yield spread between these government bonds widened further and (not co-incidentally) the dollar strengthened against the euro and most other currencies, including the rand, weakened.

The extra yield from the Treasuries would appear irresistible and has clearly contributed to dollar strength, as it has been doing consistently since June 2014. The scatter plot relating daily levels of the euro and the 10 year spread tells the story since January 2014. The negative correlation between these two series on a daily basis is a negative (-0.81) over the period. Spread wider means dollar stronger (and vice versa) would seem a very good bet for now.

What then could cause the spread to narrow and take some of the gloss off the rampant dollar? A recovery in the euro economy would lead to higher yields there. More likely sooner are higher yields in the US, especially at the short end of the yield curve, as the Fed responds to the clear signs of a good economic recovery under way. But the strong dollar itself will add to deflationary pressures in the US as the dollar prices of metals and minerals and commodities recede further, adding to deflationary pressures in the US. Exporters to the US, receiving more local currency for their sales, may well be inclined to offer their goods at lower dollar prices. These deflationary trends may well give pause to the Fed. After all, if inflation and inflationary expectations remain highly subdued why should the FED wish to slow down the economy?

In this way, higher interest rates in Europe and a slower route to what might eventually become more normalised rates in the US, may well reduce the attractions of the US dollar. Until then, the attractions of a wide spread in favour of US dollar determined interest rates is very likely to support the dollar against the euro and perhaps also to add further dollar strength and other currency weakness. Living with a strong dollar rather than trying to compete with it with higher local interest rates, which will slow down other economies, would seem to be the way for monetary policy to go, including in SA.

The JSE as a play on interest rates. The scope for still lower long term interest rates in SA

The importance of movements in interest rates for share prices over the past 12 months has never been more obvious on the JSE. Interest rates turned out to be significantly lower than expected early in 2014 and a group of large cap interest rate sensitive stocks, banks, retailers and property companies, have accordingly performed outstandingly well.

Since 1 February 2014 to 30 January 2015 our market cap weighted Index of large cap interest rate sensitive stocks generated a total return (including dividends) of 48.7%. The Global Consumer Play Index, also market weighted and one that includes Naspers and Aspen, while also performing well returned a lesser 42.9% while the JSE All Share returned 16.8%. The S&P 500, the best performer of the developed equity markets provided a 12 month return in rands of 19.6%, a highly satisfactory outcome, but less than half the return provided by the SA interest rate plays, as may be seen below.

(The index of Interest Rate Plays is made up of the following 30 companies: BGA, FSR, GRT, INL, INP, IPL, MSM, NED, RMH, SBK, TRU, CCO, CLS, CPI, FPT, HYP, NEP, PIK, RDF, RES, TFG, WBO, MPC, WHL, CPF, ATT, PSG, RPL, AEG and FFA. The Global Consumer Plays are: APN, BTI, CFR, MDC, MTN, NPN, SAB, SHF, NTC and ITU)

These interest rate sensitive stocks on the JSE should be regarded as demandingly valued by the standards of the recent past. They were priced at January month end at a well above average 16.9 times trailing earnings. They surely have benefitted from unexpectedly lower interest rates.

Presumably these interest rate sensitive stocks will remain so, making the further direction of interest rates in SA of great importance in stock selection and asset allocation. Long term interest rates in SA will moreover continue to take direction from interest rates in the US and Europe. Furthermore the value of the rand is bound to be strongly influenced by the self same interest rate trends.

Deflation is the big bad wolf threatening monetary policy. The logic of QE

Public enemy number one for central bankers in the developed world is deflation. When the CPI declines we have deflation, when it rises we have the opposite, inflation. Prices in general fall, when aggregate demand in the economy exercised by households, firms and governments, fails to keep up with potential supply. Prices rise when demand exceeds supply in general. The economic problem in the developed world and in much of the less developed world (including SA) is too little rather than too much demand that has called for highly unconventional monetary policy.

These central bankers, with modern Japan very much in mind where prices have been falling and economic growth abysmally slow since the early nineties, are convinced that deflation depresses spending and by so doing serves to prevent an economy from achieving its growth potential.

They are therefore doing all they can to stimulate more spending to arrest deflation or a possible decline in average prices. What they can do to encourage reluctant spenders is to create more money and reduce interest rates. Inflation, as they used to say, was too much money chasing too few goods. Deflation may be said to be caused by the opposite – too little money chasing too many goods. Inflation calls for less demand and so less money creation. Deflation calls urgently for the opposite – more money creation.

But while these central bankers have the power to create as much extra cash as they judge appropriate they have had to overcome a technical problem. The extra cash intended to encourage more spending may get stuck in the banking system. And when it does there may be no additional demand for goods and services and the extra money created (at no cost) may not encourage spending or lending and provide no relief of the unwanted deflationary pressures. The banks may hold the extra cash as additional cash reserves or use the cash to pay off loans they may have incurred previously with the central bank.

The mechanics of money creation go simply as follows. The cash the central banks create (or more specifically the financial claims they create on themselves called deposits with the central bank) when buying securities from willing sellers in the financial markets (typically pension funds or financial institutions of one kind or another) reflects immediately as extra privately owned deposits with private banks. In the first instance, as the proceeds of a sale of securities by a private bank customer are banked, the private bank will have raised an additional deposit liability and will receive in return an asset in the form of additional claim on the central bank. That is, the asset to match their additional deposit liabilities will take the form of an increase in their (cash) reserves at the central bank. Normally the banks will make every effort to convert this extra cash into a loan that earns them more interest. Such loans would then lead to more spending. Normally banks keep minimal cash reserves in excess of the regulated requirement to hold cash reserves in fractional (say 5%) proportion to their deposit liabilities.

But ever since the Global Financial Crisis of 2008 this has not been the case at all. The central banks, led by the US Federal Reserve Bank, have bought trillions of dollars worth of financial securities and the private banks have added trillions of dollars to their cash reserves. In the figure below we show how the assets of the major central banks have expanded over the years. Their extra assets have consisted of securities issued by governments of government agencies- for example in the form of mortgage backed securities issued by government backed mortage lending agencies Fannie Mae and Freddie Mac in the US.

It should be noted that the ECB balance sheet has been shrinking in recent years, unlike those of the other central banks. This decline in ECB assets and liabilities (mostly cash reserves of the banks) has represented additional deflationary pressure on spending in Europe. The European banks have been repaying ECB loans previously made to them and the ECB has now responded by initiating a further programme of QE, that is to say security purchases, intended to inject an extra EUR60bn a month into the banks of Europe over the next 21 months. That is to encourage bank lending and spending to counter deflation.

The important point to note is that creating money in the form of a deposit with the central bank by buying securities in the market costs society almost nothing. Creating money that is an asset of the banks and an addition to the wealth of the community does not require any sacrifice of consumption or savings, as would any other form of wealth creation. It is literally money for nothing. But in normal times too much money means too much spending and inflation. Hence the resistance in normal times to creating money – because it normally leads to inflation.

But the times have not been normal. The extra supplies of money have been accompanied by extra demands by the banks to hold money and too little rather than too much spending has remained the economic problem. Hence the case for creating still more money until deflation is conquered and central banks can get back to worrying about too much money and inflation.

The extra liabilities issued by the central bank matching the extra assets were mostly to private banks in the form of cash balances in excess of required cash reserves. In the US the banks have received 0.25% p.a on these cash reserves.

It should be notie that the US banks have begun marginally to reduce their cash reserves with the Fed and that the assets of the Fed are rising more slowly with the end of QE in October 2014. QE ended because the recovery of the US economy is well under way and presumably does not need further encouragement in the form of further increases in the supply of cash. The banks presumably have more than enough excess cash to meet the demands of borrowers from banks. It could be argued that QE at least in the case of the US – the economy is recovering – the dangers of deflation have receded and the danger of inflation taking over is judged to be absent.

There is very little inflation priced into the yields offered on 30 year US Treasury Bonds that offer yields below 3% and less than 2% more than inflation protected US obligations with the same duration. Japan and Europe, it may be presumed, will be doing still more QE or as much as it takes to get the banks to lend out more of their cash.

The problem of deflation is complicated by very low or even negative interest rates. Cash has one advantage over other assets. The income return on cash can only fall to zero. Other assets, for example government securities or bank deposits, may only offer negative interest rates. The German government, for example, can now borrow for up to 10 years, charging rather than paying interest. In other words, it can take about 105 euros from you and promise to pay you 3 euros interest and repay you 100 euros in a year’s time. In other words the transaction will have cost you 2 euros and this, alas, is the best risk adjusted return you can get, though, if prices in general decline by 2% over the year, your 100 euros will be worth as much as 102 a year before adding to your real return. But you would have done better holding cash. 100 euros in cash will still be worth 100 after 12 months and will also buy you more.

Hence deflation forces down interest rates and encourages the demand for cash (and safe deposit boxes) and discourages the demand for bank deposits and for goods and services that may be expected to become cheaper. Deflation also encourages banks and other lenders to hold cash rather than to lend it out. Hence further reason to fight deflation (and too little rather than too much spending) by flooding the system with additional cash so that the supply of cash can eventually, even with very low or negative interest rates, overwhelm the demand for cash.

Until Europe succeeds in overcoming deflation and stagnation we can expect interest rates in Europe to stay low and for the euro to stay weak; and the US dollar (offering higher interest rates) to stay strong. We may also expect deflation and low interest rates in Europe to help hold down long term rates in the US and elsewhere as European lenders seek higher yields abroad. The weak euro and stronger dollar (and perhaps also stronger emerging market currencies, including the rand) may also help restrain any increase in short and long interest rates globally. It may take some time before we can say with any confidence: goodbye to deflation and welcome back inflation.

The Monetary Policy Committee (MPC) of the Reserve Bank will be reporting back today on its first meeting of 2015.

The MPC did not have a good 2014. By the year end it had become clear that it had overestimated both SA inflation and growth in 2014 and beyond.

The estimates of inflation were overtaken by events outside SA, over which the Reserve Bank has no influence. These were events that moved global prices and interest rates markedly lower and the rand no weaker on a trade weighted basis, despite the strong US dollar. However the increases in the MPC short term repo rate in 2014, to 5.75%, by an initial 50 bp in January followed by a further 25bp in July, would have discouraged domestic spending to a degree. This was spending that in mid year gave every indication of slowing down even more rapidly than initially forecast. But the higher cost of credit had no discernible influence on inflation, dominated as it was by global price trends, especially that of oil and grains, and the exchange rate.

Hindsight would suggest that short term interest rates in SA should at worst have been kept on hold in 2014 and, better still, should have moved lower. Longer term rates certainly did, determined as they are by market forces, though they were market forces with an eye always on central bank action.

The Reserve Bank might be inclined to contest such an observation. It stressed in its statements released after its MPC meetings that fighting inflation was its primary task and moreover that it regarded its monetary policy as always accommodating, a reference to the unusually small gap between interest rates and inflation.

According to its statement in July 2014, when it raised short rates by a further 25bp:

“The MPC is also increasingly concerned about the inflation outlook, and the further upside risks to the forecast. Although the exchange rate remains a key factor in this regard, the possibility of a wage-price spiral should wage settlements well in excess of inflation and productivity growth become an economy-wide norm has increased. Although the inflation trajectory has not deteriorated markedly since the previous meeting, upside risks have increased, and it is expected to remain uncomfortably close to the upper end of the target range when it does eventually return to within the target. The upside risk factors make this trajectory highly vulnerable to any significant changes in inflation pressures.

“Although inflation expectations have remained relatively anchored, should inflation persist outside the target band, these expectations risk becoming dislodged.

“The MPC has decided to continue on its gradual normalisation path and raise the repurchase rate by 25 basis points to 5,75 per cent per annum, effective from Friday 18 July. Given the expected inflation trajectory, the real repurchase rate remains slightly negative and well below its longer term neutral level. The monetary policy stance remains supportive of the domestic economy, and, as before, any future moves will be gradual and highly data dependent.

“We would like to reiterate that monetary policy should not be seen as the growth engine of the economy. The sources of the below par growth performance are largely outside the realms of monetary policy.”

The lesson the Reserve Bank might however take from events in 2014 is that while it is true that the “the sources of the below par growth performance are largely outside the realms of monetary policy”, so is the inflation rate.

Inflation in 2015 will continue to be dominated by events beyond the influence of SA monetary policy and short term interest rate settings. For some obvious examples of only the known unknowns, the timing of the first US FED rate increase, June 2015 or later, will matter for global growth and inflation forecasts. So will the success or otherwise of European quantitative easing and how deflation in Europe presses down euro yields and hence the flow of funds both to the US and emerging markets (including SA) in search of higher yields. A possibly still stronger dollar might press further on the oil and other metal prices, meaning less inflation and possibly slower growth in the US. The economic recovery in the US, depending on its pace, may encourage tepid growth in emerging economies, adding to the attractions of their equities and currencies, including the rand. Such outcomes will in turn bring rate increases in the US either forward or back.

The MPC, as is clear from the statements it issued, worried a great deal in 2014 about the turbulence in global markets and economies and how it should react to the interest rate decisions of other central banks. As it turned out, the higher rates imposed by a number of emerging market central banks, including the SA Reserve Bank, were ill advised and are being reversed in the light of lower inflation.

The MPC will almost certainly keep its repo rate on hold today. Hopefully its future decisions will remain data dependent and not presume a so described normalisation of interest rates any time soon. Normalisation of (higher) interest rates presumes a normalisation of global economic circumstances that remain distinctly abnormal as deflation and QE in Europe confirm.

It would be wise for the Reserve Bank to realise that its influence over growth, inflation and inflation expectations is limited given the exposure of the SA economy to global forces.

There is however one feedback loop over which it has some influence. This is the loop from short term interest rates to domestic spending. Higher rates discourage such spending and lower rates can encourage it. This is the only channel of influence the Reserve Bank can rely upon to some degree.

It should therefore concentrate on ensuring that domestic demand neither adds to nor detracts from inflationary or deflationary pressures. Or, in other words, to attempt with its interest rate settings to match domestic spending (influenced as it will be by bank lending) to potential domestic production as closely as possible. If it succeeds in this, it will have done what little it can realistically hope to achieve in consistently low inflation in SA. Hoping to do more than this, especially in hoping to predict the course of global economic events, and then to react “correctly”, is beyond its limited powers. This was amply shown to be the case in 2014.

Domestic spending in SA has been running at what can be presumed to be well below normal levels and rates of growth. It can do with all the help it will be getting from lower inflation and lower fuel prices. Additional help from lower short term interest rates may well be called for in due course, if spending growth remains subdued.

The CPI in December 2014 was no higher than it was in August 2014. 

The Consumer Price Index (CPI – based to 100 in December 2012) reached the level of 111 in August. In December the CPI fell by 0.2 points and was back at the 111 level. In other words, on average, prices in SA have not changed in five months.

Headline inflation is measured as the year on year change in the CPI. Prices since December 2013 have risen 5.3%. However, if we measure the change in prices over a shorter three month period, this inflation rate is zero, way below headline inflation. If current trends continue and are extrapolated using a time series forecast, SA is heading for significantly lower inflation, perhaps below 4% by the end of 2015. Lower petrol and diesel prices in January may send the CPI still lower and reduce the forecast rates of inflation further, though it is highly likely that if the rand oil price stays where it is, the government will impose an additional excise tax on petrol, diesel and paraffin in its February Budget proposals.

A risk off day in the markets – drawing some of the implications for inflation and growth

The markets yesterday must be regarded as having had a risk off day. Global government bond yields fell further (ie bond prices rose) while most equities, including those in the US, moved lower.

The US dollar, the safe haven currency, gained further strength against the euro, trading this morning at USD1.186. This dollar strength was also highly consistent with a further widening of the interest rate spread in favour of US Treasuries over equivalent German bunds. This morning the US 10 year Treasury has yielded 1.9487% compared to the 10 year German bund that offered a mere 0.446%. The gold price also rose, providing further proof of more risk aversion in the markets.

 

What exact form the additional risks took was perhaps not so obvious. The further decline in the oil price may well be the most likely suspect. A lower oil price clearly helps consumers and household spending and must be regarded as helpful to the growth outlook, given the important share of household spending in GDP, over 70% in the US and over 60% in SA. Yet while oil consumers stand to benefit, the rapid magnitude of the oil price decline must threaten those banks with exposure to the producers and service providers to the oil sector way beyond the US oil patch.

The full impact of such large shocks to the global economy, of the kind represented by these dramatic moves in the oil price, is hard to measure accurately with any degree of confidence. The extra risks priced into the bond and equity markets generally, understandably reflect some of this. More stable oil prices at these lower levels would help calm the markets and provide time for the full impact of a permanently lower oil price (if this is to be the case) to be better calculated and priced into bond and equity values.

A permanently lower oil price is on balance likely to be helpful for the global economy that has wanted for growth in household spending. It is likely to mean faster growth with less inflation, possibly accompanied by falling prices, that is deflation. If this happens, it will mean lower interest rates and so discount rates attached to income streams expected from oil and energy consuming businesses. They may well enjoy improved operating margins as production and distribution costs rise more slowly or, better still, decline when measured in money of the day. These trends, as they materialise, should show up in higher rather than lower values attached to most listed companies.

Yet while interest rates can be expected to decline with less inflation or even deflation expected, inflation linked interest rates offered by governments may well rise as growth picks up and demands for capital to invest by more profitable businesses also gains momentum. These real rates, highly indicative of the real cost of capital for all capital raisers, have been stable over the past year at low levels. Inflation expectations in the US, indicated by the difference between the yields on a vanilla bond exposed to inflation risk and the inflation protected equivalent (known as TIPS for Treasury Inflation Protected Securities), have declined also quite sharply in recent weeks (see below where we show the premium offered for bearing inflation risk in the US over the next ten years and the 10 year real TIPS yield).

However it is of interest to observe that yesterday, while nominal rates in the US fell away, the equivalent real yield actually rose. Perhaps this indicates that while less inflation is expected in the markets, growth expectations for the US may well have improved marginally on oil price trends.

We also graph the equivalent SA trends below. While the RSA 10 year yield, having risen sharply in January, has trended lower while the real 10 year yield has been stable, about the historically low 1.7% level. Of interest to note is that nominal RSA yields have declined sharply over the past two days, by about 30 basis points, from 7.82% on Monday to 7.51% this morning, the real rates have edged marginally higher. The markets in SA are now also pricing in less inflation expected and perhaps also stronger growth expected – in line with global trends.