Rising Interest Rates Amid Moderating Economic Conditions

Global Landscape 

The world’s three largest economic blocs are rapidly losing momentum. Chinese growth has been stifled by the government’s zero Covid policy. The European economy is vulnerable to the energy crisis and weaker export demand, and the U.S. economy is now at risk from an increasingly hawkish Fed. To this end, U.S. GDP fell 1.4% q/q while real household disposable income contracted by 8.1% y/y in 2022q1 (see Figure 1 below). 

Figure 1: U.S. GDP and Real Household Income 

Source: Bloomberg, 2022 

Europe injected much less monetary and fiscal stimulus than the U.S. did at the height of the pandemic and has similarly shown no excess household demand to date. If western inflation is mainly driven by supply disruptions, then an increasingly hawkish Fed will likely lead to a recession because tighter money will only drive down demand to meet output or GDP at lower levels. China’s zero Covid policy is perhaps the largest risk factor to global demand, presenting notable headwinds for commodities and commodity-linked currencies. A significant correction in commodity prices is difficult to envisage while the Russia-Ukraine conflict is still ongoing. South African Perspective The rand remains vulnerable to moderating global trade prospects and a firmer U.S. dollar. Moreover, narrowing terms of trade are bound to exert downward pressure on economic growth in the absence of robust capital expenditure programs. A slew of high frequency data has long pointed towards elevated risks of a recession that may be accompanied by an equity bear market as early as 2022q3 (see Figure 2 below). 

Figure 2: Leading Sentiment Indicator 

Source: Bloomberg, 2022 

The unabating supply-side shocks, chronologically stemming from global lockdown restrictions, geopolitical tensions, as well as reduced levels of industrialisation from China, has now left the small and open economy of South Africa more susceptible to global inflationary tailwinds. To this end, headline inflation during the month of May 2022 breached the SARB’s MPC target for the first time in five years, printing a staggering 6.5% y/y (vs. 6.1% y/y Est.). On the other hand, core prices which exclude volatile items, remain below the central bank’s mid-point target of 4.5% (see Figure 3 below). 

Figure 3: South Africa Core and Headline CPI YoY 

Source: Bloomberg, 2022 

Notwithstanding limited second round effects underpinned by high levels of unemployment and muted household demand levels, local monetary policy authorities continue to front-run global policy makers, particularly the U.S. Federal Reserve. This can be justified by the need of high interest rates in funding South Africa’s ailing fiscal deficit. Failure to keep up with global policy trends could worsen the risk of pass-through from a material depreciation in the rand. Following the May inflation shock and the Fed’s decision to hike its policy rate by 75-bps, the domestic Forward Rate Agreement (FRA) market is now pricing in a 76% probability of a 75-bps hike in the repo rate at the July MPC meeting. On the other hand, the FRAs are also pricing in another 300-bps worth of rate hikes over the next two years. The implied rates have increased steadily over the last year (see Figure 4 below). 

Figure 4: FRA Implied Policy Changes 

Source: Bloomberg, 2022 

Concluding Remarks Our view is that the fragility of the local economy is unlikely to absorb aggressive policy tightening. Steep interest rate hikes could tip the economy into a recession, more so when production remains fundamentally weak. And in the absence of costs associated with trade wars and supply-side rigidities, elevated inflation pressures appear less likely to be maintained by a moderating macroeconomic backdrop. Risks to our views primarily stem from tighter global policy conditions and the repatriation of capital associated with it. Moreover, a passive and deteriorating fiscus poses a notable challenge in absorbing the persistence of cost-push inflation. In practical terms, if the energy crisis is left unabated, if the local economy remains less diversified, and if the size of our debt book continues to increase, domestic interest rates will likely follow suit. Against the balance of these risks, our views are skewed towards a more gradual hiking cycle in the interest of sustainable economic recovery. Quantitatively, our short-term interest rate expectations remain aligned with those of the implied policy path of the SARB’s Quarterly Projection Model (QPM). We currently expect the repo rate to increase by 100-bps to 150-bps over the next two years, which is in stark contrast to the 300-bps penciled in by the FRAs over the same forecasted period (see Figure 5 below). 

Figure 5: TAM Interest Rate Outlook 

We do however remain data dependent on the above and other unforeseen shocks and will therefore adjust our views accordingly if required. Fund Comment Our cash and income funds remain well positioned for the current hiking cycle, as we largely hold floating rate instruments which will all reset their interest rate coupons to the new higher rates within the next few weeks and months. This will serve as much needed relief to risk averse income investors following the deep interest rate cuts sustained at the height of the Covid-19 outbreak. 

Taquanta Asset Managers