The South African economy, although small, has become well integrated into the global economy. The positive implication of this is that it facilitates foreign investment which supports local economic growth. Under Trevor Manual as Finance Minister, South Africa became an attractive destination for foreign capital as a result of tax reforms, fiscal discipline and the liberalisation of exchange controls. The flipside of being globally integrated is that our economy is susceptible to capital mobility which in turn is catalysed by factors such as investor sentiment, changes in economic growth, government deficits, exchange rates, interest rate differentials and relative levels of inflation, amongst other reasons.
To help navigate these dynamics, the SARB implements monetary policy that targets price stability, which ensures that the economy grows in a balanced and sustainable manner. Because of the tight linkages between global economies, it is not surprising that the actions of the Federal Reserve have a large impact on smaller economies such as ours. Figure 15 shows the close relationship between the Fed funds rate and the Repo rate, after applying a lag between the two series.
Over the last 15 years, the Repo rate has paralleled the Federal funds rate (17 month lag) with a median gap of 5.5% that has ranged between 4.75% and 6.75% for 80% of the time.
As US interest rates have begun to normalise (rise), emerging market vulnerabilities have begun to show. One of the factors is that emerging markets are running worryingly high twin deficits (of which South Africa is one of the main culprits) and as such have become over reliant on capital inflows to fund these imbalances. As US yields rise, capital has been attracted away from other markets and in many instances, emerging market assets, back into the USA. This leads to weaker emerging market currencies and increased pressure for emerging market central banks to raise rates.
Based on the relationship in Figure 15, the implication is that the SARB should raise rates a further 100bp over the next 12 months. This picture is in stark contrast to the consensus 25bps hike which is penciled in by local participants in our market – seven out of nine contributing economists to Bloomberg are predicting 25bps higher and the money market is pricing in no interest rate hikes.
Although there seems to be a disconnect between the historical trend and how our market is viewing the current interest rate cycle, it is worth noting the positives which could ‘make this time different’. These include:
- Ramaphosa’s turnaround plan which may translate into a boost in fixed investment;
- Prevailing weak inflation pressures (the rand would need to weaken significantly to push the inflation forecast above the 6% inflation target ceiling);
- The smaller-than-expected current account deficit (2.2% of GDP) in 4Q18;
- The expected improvement in GDP growth in the year ahead;
- Fed officials have begun paring back their interest rate forecasts;
- The European Central Bank has changed their outlook and opted to hold interest rates at record lows for longer than anticipated.
We will add some extra requirements which we believe are important for SA rates to buck the long-term trend, these include:
- SA to avoid a Moody’s downgrade on 29th of March;
- Global liquidity conditions to improve;
- Global trade tensions to ease and;
- For the election to go off smoothly.
In the meanwhile, we will continue to apply a margin of safety to all the investments which we hold in our funds whilst actively scouting for opportunities where the market is applying irrational pricing.