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Cape Town - Lower interest rates encourage investment spending and consumer spending, driving an acceleration in economic growth, says Overberg Asset Management (OAM) in its weekly economic overview.
Lower interest rates are unequivocally good news for the All-share Index, which has notched up successive all-time highs last week rising closer to the key 60 000 mark.
Adding to the hope of a recovering economy, OAM says there is confidence that the economy has bottomed out and will record positive GDP growth in the second quarter.
South Africa economic review
• Consumer price inflation (CPI) slowed for a sixth straight month from 5.1% year-on-year in June to 4.6% in July below the 4.7% consensus forecast. The sharp decline is attributed to a moderation in electricity tariffs, lower fuel prices and a continued drop in food price inflation. Electricity price inflation increased by just 2.1% compared with the 9.4% increase in 2016.
In July petrol and diesel prices decreased by a further 68c and 60c per litre respectively. Food price inflation decreased from 7.0% to 6.8% despite the rise in meat price inflation from 13.0% to 14.4%. Core CPI, excluding food and energy prices, also decreased from 4.8% to 4.7% helped by a strengthening rand and weak domestic demand.
Inflation is expected to remain within the Reserve Bank’s 3-6% target range over the remainder of the year, averaging 5.2% in 2017 compared with 6.3% in 2017. Falling inflation paves the way for the Reserve Bank to continue easing monetary policy. (See Bottom Line for further analysis).
• The Reserve Bank’s composite leading business cycle indicator, which measures expected business conditions 6-9 months’ ahead, eased slightly from 95.8 in May to 95.7 in June. The leading indicator has slipped steadily from its recent peak of 98.3 in February.
Two of the nine sub-indices fell, namely the number of building plans passed and the twelve-month percentage change in job advertising space. The biggest positive contributors were the composite leading business indicator of South Africa’s major trading partners and the increase in manufacturing orders.
The leading indicator confirms a strengthening in global demand but continued weakness in domestic activity.
• Combined foreign investor inflows into South Africa’s bond and equity markets increased sharply last week to R4.7bn, marking the biggest inflow in four weeks. Foreign inflows into the bond market measured R3.44bn over the week and R2.138bn for the month-to-date raising year-to-date inflows to R51.866bn.
Year-to-date inflows into the equity market have been negative at -R44.867bn although there are early signs of a change in trend. Foreign investor inflows into the South African equity market turned positive in the past week to the tune of R1.286bn paring back the month-to-date deficit to -R0.428bn.
The week ahead
• Private sector credit extension: Due Wednesday 30th August. Private sector credit extension (PSCE), which grew at a lackluster 6.2% year-on-year in July is expected to show a slight uptick in August. PSCE should respond positively to the Reserve Bank’s 25 basis point interest rate cut in mid-July.
• Producer price inflation: Due on Thursday 31st August. Producer price inflation (PPI), which fell sharply from 4.8% year-on-year in May to 4.0% in June is expected to decelerate further to 3.4% in July, according to consensus forecast. Food and fuel prices, the main contributors to PPI, have continued to fall amid the post drought recovery in agricultural output and the decline in rand-based oil prices.
• Trade balance: Due Thursday 31st August. The trade balance is expected to build on the robust surplus of R10.7bn posted in June. A surplus of R7.1bn is penciled in for July according to consensus forecast. For the first six months of the year the trade balance achieved a surplus of R27.7bn compared with a deficit of R5.0bn over the same period last year.
Imports have slowed due to weak domestic demand while exports have been supported by strengthening global trade. The rising trade surplus bodes well for the country’s current account balance and hence the rand.
• Vehicle sales: Due on Friday 1st September: The National Association of Automobile Manufacturers of South Africa (NAAMSA) is expected to report a further year-on-year increase in vehicle sales in August building on the positive sales growth achieved in June and July.
Vehicle sales, which grew in July by 4.1% on the year are expected to increase by 3.2% in August according to consensus forecast, helped by buoyant export demand and low statistical base factors.
• Absa manufacturing purchasing managers’ index: Due on Friday 1st September. The manufacturing purchasing managers’ index (PMI), which fell heavily from an already depressed 46.7 in June to 42.9 in July is expected to show some recovery in August.
However, the PMI is likely to remain below the key 50-level, signalling contraction. The PMI, while boosted by strengthening export demand is held back by political and policy uncertainty.
Technical analysis
• The rand is testing key resistance at R/$13.00, which if broken would target further gains to R/$12.50 and thereafter R/$12.00.
• The US dollar index has tried but failed to break through a major 30-year resistance line suggesting the three-year bull run in the dollar may be over.
• Following the announcement of the snap election the British pound has broken above key resistance at £/$1.30 which has now become a key support level and should promote further near-term currency gains.
• The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.
• The US 10-year Treasury yield has failed to break below key resistance at 2.0% raising the probability that the multi-year bull trend in US bonds is over.
• The benchmark R186 2025 SA Gilt yield is trading in a tight trading range of 8.5-9.0%. A break above 9.0% is required for the yield to move decisively higher towards the 10.5% target level.
• Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdqaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.
• The Brent oil price has broken above key resistance at $50 and likely to remain in a trading range of $50-60 over the foreseeable future. Base metal prices are in a bull trend confirmed by copper’s increase above key resistance at $6 000 per ton.
• Gold has developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1 400 target level.
• The break above 54 200 on the JSE All Share index projects an upward move to 60 000 marking a new high for the JSE.
Bottom line
• The All Share index notched up successive all-time highs last week, rising decisively above 56 000 and ever closer to the key 60 000 mark.
There is confidence that the economy has bottomed out and will record positive GDP growth in the second quarter (Q2), ending the official recession which began in Q4 last year.
• The prospect of lower interest rates is driving equity markets higher. The sharp decline in inflation makes a September interest rate cut increasingly likely with three or four further rate cuts expected thereafter.
Consumer price inflation (CPI) fell in July for a sixth consecutive month to 4.6% year-on-year from 5.1% in June. CPI is well below the recent peak of 6.7% in December 2016 and halfway between the lower and upper band of the Reserve Bank’s 3-6% inflation target.
The SA Reserve Bank initiated its interest rate cutting cycle on 20th July with a 25 basis-point rate cut.
• Lower interest rates have the effect of increasing the intrinsic value of investments. To put it another way, lower interest rates increase the present value of future returns of investments. If you expect to receive R1 000 in 20 years’ time and the interest rate is 10%, the present value will be R144.64.
At an interest rate of 5%, the present value increases sharply to R376.89. Equity markets are currently experiencing this kind of repricing.
• There is generally a gap or spread between interest rates (current repo rate is 6.75%) and dividend yields (currently 2.75% on the All Share Index). This current 4% gap/spread will narrow when interest rates drop, making equities more attractive.
The narrower the spread, the more attractive investments in the stock market become.
• Lower interest rates encourage investment spending and consumer spending, driving an acceleration in economic growth and hence company earnings growth and the equity market.
Lower interest rates incentivise businesses to start investing their cash reserves in search of a better yield or to take on more debt and finance new expansion. Lower interest rates reduce the debt servicing costs of indebted households and may encourage them to borrow more, with the effect of raising disposable income and consumer spending.
• Interest rate futures indicate a 64% probability of a 25 basis-point rate cut at the Reserve Bank’s upcoming policy meeting in September. A strengthening rand may allow for a deeper rate cutting cycle than generally expected.
• Lower interest rates are unequivocally good news for the All Share Index. Lower interest rates will lead to higher intrinsic equity valuations, to capital transfers from money markets into equities, and will boost economic growth prospects and company earnings.
For the full report, including a look at international markets, click here.
* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.
Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.
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