Inside Insights 2 Aug 2010

Investment Intelligence|Inside Insights

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

Added on 02 August 2010 @ 10:41 AM

Euro bounces back

How quickly roles can be reversed. As the fears over the sovereign debt and banking crisis in the eurozone decline, the euro hit a 12-week high against a broadly weaker dollar as month-end demand supported the single currency (investors selling off dollars before the end of the month to hedge the currency exposure of their holdings in US assets). Eurozone economic sentiment jumped to a 28-month high, with Germany registering the biggest increase. Furthermore, German unemployment declined for the 13th consecutive month, falling to its lowest level since November 2008. The good macro data follows on from previous weeks’ fairly positive bank stress test results and successful debt auctions to paint a picture of a continent not quite as down and out as many thought.

In contrast, the market is becoming more nervous about growth in the United States. The Federal Reserve’s ‘Beige Book’ assessment of economic conditions pointed towards slower economic growth in the second half of 2010. US durable goods orders unexpectedly declined in June for the second consecutive month, in line with reports that manufacturing activity is levelling off. Adding to the anxiety in the US were comments from Moody’s Investor Service that the US needs to decrease its high debt level in order to maintain its AAA credit rating. Finally, a key Fed official commented that the US could experience Japan style deflation. The upshot of all this is that interest rates in the US will remain low for longer. This in turn suggests the ‘search for yield’ will also last longer, and investors will turn to emerging market destinations such as South Africa that offer both better growth prospects and higher interest rates.

We should not be too surprised then, that the rand has followed the euro stronger against the dollar. The rand hit a 3½ month high against the on Thursday, reaching R7.26/$. Foreign demand for local assets seems enormous; in the year-to-date foreigners have purchased a net R56.5bn of government bonds, with a net R16.1bn purchased in the past two weeks alone. The Reserve Bank’s decision to keep interest rates steady last week also supported the currency. Against a trade-weighted basket of currencies, the rand has firmed about 4% this year. However, it is important to keep in mind that the while the rand may keep up its strong run against the dollar in the short-term, it is not a one-way bet. If US growth falls back sharply, global risk appetite could collapse entirely, with rand being one of the first casualties (as we saw in September 2008). Meanwhile, we have to live with the impact of a strong rand: lower inflation, but a struggling export sector.

Consumer inflation surprisingly low

Despite the expected impact of the World Cup – and the anecdotes of opportunistic pricing - headline inflation surprised sharply on the downside in June. Year-on-year growth in CPI came in at 4.2%, compared with the market expectation of 4.5% and May’s inflation number of 4.6%. Inflation has been within the Reserve Bank's 3% -6% target range for the fifth month in a row. Lower food prices and a decline in insurance costs were the main contributors to the surprisingly low figure. Food prices fell by 0.5% between May and June, and were unchanged between June 2009 and June 2010. Fruit prices, in particular, have fallen substantially over the last year, but grains, meat and sugar prices are also down. Insurance costs, which constitute 7.7% of the inflation basket, fell by 1.2% between May and June. On the other hand, administered price inflation remains high. Administered prices, which include electricity tariffs, rose 10.8% between June 2009 and June 2010.

Producer inflation is moving in the opposite direction to consumer inflation, surprising on the upside by coming in at 9.4% year-on-year from 6.8% in May. Much of the surge in producer inflation has been due to higher commodity prices, which will not necessarily feed through to consumer prices. Nonetheless, it probably adds weight to the Reserve Bank’s decision not to cut interest rates at the most recent MPC meeting. At least we know interest rates should not be hiked anytime soon. Historically interest rates only rise after 12-18 months of strong credit growth. But the demand for credit has turned positive only very tentatively. Private sector credit extension rose for only the second month - following seven consecutive annual declines - by 0.92% year-on-year in June, following the meagre 0.8% gain in May.

The Week Ahead

• The petrol price will come down by 10c/l on Wednesday, while the diesel price will drop by 13c/l.

• Kagiso manufacturing purchasing managers’ index (PMI) for July will be released on Monday. The PMI fell below the 50 index points level that separates expansion from contraction in the sector, hitting 48.4. The PMI had in previous months shown a strong recovery, reaching as high as 60.4 points as a global restocking cycle got underway after the worldwide recession. But with much of the restocking now complete, manufacturers locally and globally will rely on final consumer demand to drive growth. In South Africa, this demand is still sluggish, therefore the PMI is not expected to have moved above 50 in July. The strong rand also continues to weigh on the sector, the local economy’s second largest. Global PMI numbers will also be released this week, and will be key to giving the market direction.

• Naamsa releases new vehicle sales numbers for July on Tuesday. Vehicle sales also experienced a strong rebound following the recession of 2008/2009, rising by 26.6% year-on-year in May and 14.4% in June. This was also partly attributed to pre-World Cup purchases from the likes of car rental firms. As such, the growth rate is expected to have declined in July.

• The South African Chamber of Commerce and Industry releases its monthly Business Confidence Index on Thursday.

• The Reserve Bank will release data on its holdings of gold and foreign exchange reserves on Friday. The data will be closely eyed for any sign that the Bank has been purchasing unusually large amounts of forex in an attempt to stop the rand from strengthening too much. However, the Bank has made no firm policy announcement on the matter, so economists expect only a nominal amount of accumulation to have taken place in July.

Fairbairn Capital | Old Mutual

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