Inside Insights 26 October 2009

Investment Intelligence|Inside Insights

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

Added on 26 October 2009 @ 9:53 AM

Eventful week on currency markets

Global risk appetite has improved dramatically since March, while confidence in the US dollar has waned. The combination of these two factors has caused the dollar to depreciate against a basket of currencies, while higher-yielding and commodity-backed currencies (such as those of Canada, Australia, Brazil and South Africa) have been pushed up by a flood of portfolio inflows. Two events last week brought home how uncomfortable the weak dollar is making life for producers and exporters elsewhere in the world. Brazilian authorities imposed a 2% financial transaction tax on foreign investments in stocks and fixed income securities to stem the further appreciation of the Brazilian real. In reaction, Brazil's main equity index, the Bovespa, fell 2.88% and the real depreciated 2.1%, although the next day both gained more than 1%.

The other event was a rumour that South Africa's government was going to "freeze" the rand, which lead to the rand losing more than 2%. The rumour was swiftly denied, and the rand clawed back some of the losses, closing the week at R7.46/$. As the Brazilian example shows, intervening in foreign exchange markets is a difficult strategy.

One country has been doing it successfully for years, though, is China. China reported robust third quarter year-on-year GDP growth of 8.9%, up from quarter two's 7.9% (but less than the expected 9.1%). The Chinese renminbi is pegged to the dollar, so as the dollar slides against other currencies, the renminbi is effectively getting a free ride, boosting the competitiveness of Chinese exports.

A final consequence of the weaker dollar has been rising commodity prices. While higher gold and platinum prices are a boon for the South African mining sector (leaving aside the issue of a stronger rand), oil at the best levels so far in 2009 - closing the week at $77/barrel - will be of concern worldwide. Supply and demand fundamentals suggest that crude oil prices should remain in check. Should they surge ahead on a weakening greenback, they could choke off the fragile global economic recovery.

No surprises

As expected, the Reserve Bank's Monetary Policy Committee (MPC) kept the repo rate unchanged at 7%. It was the last MPC meeting to be presided over by outgoing governor Tito Mboweni. In reaching its decision, the MPC noted that there were mixed signals on the economic growth front. Mining production had improved, while the contraction in the manufacturing sector had slowed down. However, on the consumption side, retail sales and credit growth data have been very disappointing. Data released last week showed that civil debt judgements continued to rise in by 27.8% year-on-year in August, up from 12.9% in July.

The Reserve Bank did not change its short-term inflation outlook since the previous MPC meeting (when rates were also kept on hold) as the impact of the stronger rand is likely to be offset by rising administered prices. The Bank expects CPI inflation to move into the 3% - 6% target range on a sustained basis by the second quarter of next year. Over the longer term, the MPC noted that global inflation is likely to be subdued for the next few years, although higher commodity prices, fuelled by a weaker dollar, cold give rise to inflationary pressures. Locally, Eskom's proposed electricity tariff increases were noted as the main longer term threat to the inflation outlook.

With all indications that we are at the bottom of the interest rate cycle, the market will begin looking toward the start of the next rising cycle. As the graph suggests, the forward rate agreements (FRA) market is pointing to a repo increase as early as the second half of next year. The 9 x 12 FRA is a forward contract for an interest rate commencing in 9 months' time for three months, and is currently trading at 43 basis points above the repo. A weak economic recovery could delay that increase for a few more months, though.

The Week Ahead

An eventful week lies ahead. On Tuesday, Finance Minister Pravin Gordhan will present the Medium-Term Budget Policy Statement in Parliament. The market will pay close attention to Gordhan's revenue and expenditure projections for the next three years, given how the outlook has changed since the Budget Speech in February. Back then, the economy was expected to grow by 1.2% this year and the budget deficit was expected to be 3.8% of GDP. Today we know that the economy will probably contract by about 2% in 2009, and that the deficit could balloon to 8% as a result of a revenue (tax) shortfall in the region of R70bn. While enormous budget deficits have become the global norm as governments have tried to spend their way out of recession this year, they are not sustainable. The market will thus want the reassurance that Gordhan plans on brining the deficit under control over the medium term. This will happen as the economy recovers and hence tax revenues improve, but it will also require more disciplined spending by government.

StatsSA will release local inflation data for September this week. Year-on-year growth in the consumer price index (CPI) slowed down to 6.4% in August, from 6.7% the month before. Particularly encouraging was the decline in food inflation to 6.2% in August, a trend which is expected to continue. However, the impact of fuel prices is expected to start pushing CPI inflation up over the next few months. This is because the sharp fall in fuel prices in the last months of 2008 has created a very low statistical base. The consensus market view, according to Reuters, is for September CPI inflation to come in at 6.2%. CPI inflation has been outside the Reserve Bank's 3-6% inflation target range since April 2007, and will probably only move into that target range on a sustained basis in the second quarter of next year.

On the producer inflation side, the market expects year-on-year growth in PPI for September to remain negative at -2.7% year-on-year. August's -4% PPI number was the fourth consecutive negative month, with the strong rand a significant contributor.

The Reserve Bank releases money supply (M3) and private sector credit extension (PSCE) growth for September this week. PSCE slowed to 2.34% in August, and is expected to slow even further in September to 2.25%, indicating continued weakness in local demand, and supporting the view that inflation is likely to remain low over the next year (unless, of course, those electricity tariff hikes cause considerable damage, and the oil price continues its upward trend).

Fairbairn Capital | Old Mutual

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