Inside Insights 22 February 2010

Investment Intelligence|Inside Insights

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

Added on 22 February 2010 @ 9:45 AM

Gordhan delivers the goods

Finance minister Pravin Gordhan did not have a lot of room for manoeuvre when he delivered his first budget last week, due to a weak economy and a massive tax revenue shortfall. But at least we can all be thankful that we entered the recession with state finances in decent shape (unlike Greece, for instance). There was never going to be large scale tax relief, but Gordhan did find R6.5bn to adjust tax brackets for inflation, providing some relief to tax payers especially in the lower income brackets. And tax payers will find this bit of relief very useful when one considers the electricity and other tariff increases in the pipeline. In other words, some of the burden of developing infrastructure has been shifted from the taxpayer to the consumer who, in the end, is really the same person.

While individuals focused on tax brackets and the inevitable increases in sin taxes and fuel levies, the market only really cared about two things: the projected deficit, and the direction of economic policy. On the former, the economic growth forecast was revised upwards from 1.5% in 2010 to 2.3%, meaning better tax revenues and hence a slightly smaller deficit. Given the global concerns about public debt the market found comfort from the commitment to reducing the deficit from 7.3% of GDP in the current fiscal year, to 4.7% in 2012/13 (of course the total public sector borrowing requirement, including the parastatals, will still be a large 7% of GDP by then).

The other big issue was macroeconomic policy. Gordhan reaffirmed the Reserve Bank's 3%-6% inflation target, but emphasised that the Bank should be flexible in pursuing this mandate. He also stated that the Bank should continue to accumulate reserves to subdue the volatility of the rand. This was rather odd, seeing as the Bank has not done much accumulation, but it did signal that the government would continue to let the market set the exchange rate. While the market reacted favourably to Gordhan's commitment to prudent policies, there is of course no guarantee that his targets will be met. To reduce the deficit, government spending growth (including salaries) will have to be contained to just 2% above inflation over the next three years, while unnecessary spending will have to be slashed. And economic growth will have to be quite robust over that period. If not, we may face the prospect of higher tax rates in the near future.

Fed takes first small step towards the exit

Global equity markets had a slightly better week, with fears over Greece's debt problems taking a back seat as investors had other news to focus on for a change. The Dollar Index, which measures the dollar's performance against 6 major currencies, rose to the highest level in 8 months after the US Federal Reserve raised its discount rate (the rate it charges banks for emergency loans) to 0.75% from 0.5%, to wean banks off government funding. While the Fed emphasised that its main policy rate, the Fed funds rate, which is more applicable to business and consumer borrowing, will remain at near zero levels for months still, the market took it as a clear signal of the eventual tightening of monetary policy. Global stocks fell on this news. On the other hand, the stock market was supported by upbeat corporate earnings reports, a strong reading on the US leading indicator and positive manufacturing survey data. European shares also posted four consecutive positive days on better than expected results from some of Europe's largest corporations.

With the market now expecting that the Fed will hike rates before year-end, while the likelihood of a similar hike by the European Central Bank is now much smaller, it is no surprise that the euro fell to 9-month lows against the dollar. As is typically the case, commodity prices fell as the dollar rose. Gold faced an extra headwind from the International Monterey Fund's (IMF) decision to sell 191.3 tons of gold in the open market. However, the rand again failed to follow the euro lower as investors seem comfortable with local prospects and economic policies. The rand gained more than 10c on Wednesday after the budget contained no plans to peg the currency ( it fell back later in the week). The bond market also firmed as the budget outlined that the government's main source of funding will remain long-term bonds, with issuance expected to decline after 2011, and due to clarity over the inflation targeting policy. Local stocks managed to end the week higher, despite the volatility in commodity prices.

The Week Ahead

Locally, the focus this week will be on the National Energy Regulator's (Nersa) announcement of electricity tariff increases (expected on Wednesday). As is well known by now, Eskom applied for 35% p.a. increases over the next three years. If granted, these increases will not only have a big negative impact on household disposable income and corporate profitability, but could also lead to so-called second round inflationary pressures. As such, they would make it very difficult for the Reserve Bank to even contemplate another cut in the repo rate. On the other hand, without these increases, Eskom will struggle to finance its massive R385bn capacity expansion programme, as it has basically exhausted its borrowing ability off its own balance sheet, while the government has not stepped in with new loans. South Africa desperately needs more electricity generating capacity, as we certainly cannot afford a repeat of 2008's rolling blackouts. The only workable solution seems to be for a equity partner from the private sector to get involved in Eskom's new projects. Nersa clearly has a difficult decision to make, and it is one that will have far-reaching implications for the economy over the next few years.

StatsSA will release Q4 2009 GDP data on Tuesday. South Africa emerged from recession in Q3 with a 0.9% quarter-on-quarter (seasonally adjusted and annualised) growth rate. The manufacturing and mining sectors both having had a positive quarter in Q4, with the former benefiting from an inventory rebound. Vehicle sales have also finally turned the corner towards the end of the quarter, while real retail sales growth surprised on the upside in December, but was still negative at -3.7% year-on-year. All in all, then, Q4 is expected to deliver another positive quarter, with growth around 3%. For 2009 as whole, though, the data is likely to show a contraction of around 1.8%.

StatsSA will also release January inflation data this week. Consumer inflation, as measured by annual changes in the consumer price index (CPI) rose to 6.3% in December due to technical factors. These technical factors (a low base of comparison in January 2009) will probably push CPI a bit higher still, to around 7%, before falling back in the second quarter. Nonetheless, there has been a significant slowdown in the price growth of food, which should continue and will support the slow recovery in consumer spending.

Producer inflation (PPI) moved into positive territory in December for the first time since April, rising to 0.7% from -1.2% in November. The increase has been due to the recovery in commodity prices, but the strong rand has offset a part of the related costs to producers.

The Reserve Bank releases credit extension (PSCE) and money supply (M3) growth for January on Friday. PSCE rose in December to -0.8% year-on-year, but was still negative pointing to the very limited demand for credit, especially from businesses. Household demand for credit grew marginally in December, suggesting that the impact of lower interest rates is starting to be felt.

Fairbairn Capital | Old Mutual

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