Inside Insights 16 May 2011

Investment Intelligence|Inside Insights

A weekly, in-depth yet concise report on the most important recent market movements and economic developments.

Added on 16 May 2011 @ 9:48 AM

REALITY SINKING IN

The market continues to be paying close attention to two ongoing stories, the PIGS government debt saga and the oil price. However, in contrast to the first four months of the year, investors now seem to be fretting over falling, not rising, oil prices. Recent data reflecting slower growth the US, tighter monetary policy in China, and a firmer US dollar, led to a sell-off in commodities. Lower oil prices are undoubtedly good for consumers, but also signify weaker demand and a slower economic recovery. While the oil market might have been excessively perky in recent months, and a correction overdue, the long-term demand picture suggests that high petrol prices are something we'll have to live with. Until electric cars become mainstream, anyway. Over short-term periods, commodities (including oil) are volatile, as the past few weeks remind us. It is for this reason that central banks tend to exclude fuel prices when setting interest rates, focusing instead on ‘core' inflation.

Regarding the PIGS, and Greece specifically, the (euro) penny seems to be finally dropping. One year after imposing a harsh austerity programme in return for a bail-out package, Greece is no closer to getting its debt to sustainable levels, with a debt to gross domestic product (GDP) ratio of around 140% and a budget deficit in double digits. The bail-out package was originally conceived as a bridging loan for a country facing cash-flow problems; most analysts now believe the government is bankrupt, and that restructuring of its debt is inevitable - or worse, an exit from the eurozone. Ratings agency Standard & Poor's cut Greece's sovereign rating to B, the same level as Belarus. Only European politicians have continued to insist that there is no need for restructuring, but even some of them might be facing up to reality. Rumours of secret meetings about debt restructurings and eurozone exits resurfaced over the last week or so, pushing the euro lower against the dollar.

SARB WORRIED ABOUT GROWTH AND INFLATION

There were no surprises from the Reserve Bank's Monetary Policy Committee (MPC) meeting, though there were plenty of worried noises. The MPC left the repo rate unchanged at 5.5%. It now expects consumer inflation to temporarily breach the 6% upper limit of the target range in the final quarter of 2011, before peaking at 6.3% in early 2012. The average inflation rate for 2011 is expected to be 5.1%, up from the 4.7% forecast at the time of the previous meeting. While acknowledging that inflation was being driven by cost pressures, such as higher electricity tariffs and fuel prices, rather than demand pressures, the MPC stressed that it would "monitor closely any indications of second round effects on inflation…and would not hesitate to respond timeously".

On the economic growth front, the MPC once again highlighted the uneven and uncertain nature of the global economic recovery, with government debt problems in the developed world, while some emerging markets risk overheating. Higher oil and food prices act as a drag on growth in the former, while acting as a source of inflation in the latter. Locally, the economic recovery appears to be on track, but rising food and administered prices (such as electricity tariffs) are hitting consumers' pockets. The Bank specifically also noted the lack of local job creation. It reduced its 2011 growth forecast slightly from 3.7% to 3.6%, a rate well below that of our emerging market peers.

The combination of higher-than-expected inflation and lower-than-expected growth creates a headache for the MPC. It is most likely to adopt a very cautious wait-and-see approach with a greater weighting toward supporting growth than during previous cycles. The first interest rates hike is likely to occur in early 2012, with the remainder of the hiking cycle being quite mild. What this suggests for investors, unfortunately, is declining real (after-inflation) returns on money market and other fixed rate investments for the rest of 2011.

THE WEEK AHEAD

• Statistics South Africa releases April consumer inflation numbers on Tuesday. The consumer price index (CPI) rose by 4.1% year-on-year in March, from 3.7% year-on-year the month earlier. Higher food, fuel and electricity costs have largely been behind the rising inflation rate. A big petrol price hike in early April (54c/l) will have contributed to a higher inflation rate in April, expected to be around 4.4% year-on-year.

• Also on Tuesday, StatsSA will release retail sales numbers for March. Real retail sales declined for the second month in a row to 5.6% year-on-year in February, from 6.3% in January. The recent peak of 8.3% was achieved over the busy December holiday period. With higher fuel prices constraining household finances, and in the absence of meaning employment growth, retail sales growth is not expected to have improved much in March. There will also be a drag for statistical reasons as March 2010 was a particularly strong month.

• Wednesday is a public holiday, as South Africans vote in local government elections.

• International key events and data releases this week: Japan April consumer confidence and February machine tool orders, and quarter 1 GDP; eurozone consumer inflation for March and consumer confidence for May; US NAHB homebuilders survey and Empire State Manufacturing index for May, existing home sales and leading indicator for April; UK April retail sales and employment report.

Fairbairn Capital | Old Mutual

Investment Intelligence|Inside Insights