Global Markets
- 4th quarter 2003
Interest rates - how low will they
go?
The current domestic interest rate
environment highlights that it is
not possible to please everyone
all of the time. After experiencing
a 4% rise in our domestic interest
rates during the course of last
year, we have so far this year witnessed
four interest rate cuts totalling
5%. Prime, now at 12%, is at its
lowest level in 17 years. In a survey
of private sector economists conducted
recently by I-Net Bridge, the general
view was that there is likely to
be one further cut in domestic interest
rates of 1% in February 2004, which
they expect to be the final reduction
in this current easing cycle. However,
the Reserve Bank have surprised
investors and analysts on more than
one occasion this year, so don't
discount the scheduled December
10th and 11th Monetary Policy Committee
meeting, especially in light of
the continued Rand strength, combined
with record low consumer inflation
levels.
While the news of further interest
rate cuts is good news to all those
who are repaying debt, spare a thought
for the many retired investors who
are living on a fixed amount of
capital generating an income based
on a return linked to the Prime
rate of interest. Hypothetically,
an investor who had R500 000 invested
a year ago at 17% is likely to have
earned a monthly income of R7 083.
This same lump sum, one year later,
is likely to be generating a monthly
income in the region of R5 000.
This translates into a significant
impact on monthly cash flow - a
reduction of more than R2 000 per
month (or 28%).
How then are declining domestic
interest rates and declining inflation,
coupled with a stronger Rand, likely
to impact on local business and
domestic equities? Let us look at
two possible scenarios - the first
being those local companies who
are not Rand hedged and who receive
all their earnings in Rands, while
at the same time paying all their
expenses in Rands (e.g. local retailer).
For these companies the scenario
referred to above is favourable
for the following reasons: the cost
of capital becomes that much cheaper,
while at the same time, because
their income and expenses are both
in Rands, they are able to compete
favourably in the domestic arena.
Furthermore, domestic demand should
be on the increase as domestic consumers
are inclined to spend more in an
environment of falling interest
rates. However, the picture is not
as favourable for those companies
who earn their income in foreign
currency, but pay their expenses
in Rands (e.g. gold mine). In this
scenario, while declining interest
rates and declining inflation levels
are good news, the strong Rand is
likely to impact on their earnings
making them less competitive when
selling their products in overseas
markets. Recently there have been
an increasing number of articles
in the press about companies in
this very predicament, who are being
forced to reduce costs - more often
than not, at the expense of jobs.
This is something that South Africa
can ill afford.
In summary, it is clear that it
is not possible to "please all of
the people all of the time" especially
when it comes to issues like our
domestic interest rates and the
Rand.
In a unanimous decision at their
latest meeting in October, the Federal
Reserve kept short-term interest
rates on hold at 1%. In a statement
following the meeting, the Federal
Reserve Open Market Committee is
reported to have said: "the Committee
judges that, on balance, the risk
of inflation becoming undesirably
low remains the predominant concern
for the foreseeable future. In these
circumstances, the Committee believes
that policy accommodation can be
maintained for a considerable period".
This implies that they are likely
to leave short-term interest rates
lower for longer.
Third quarter growth came in well
ahead of expectations - at 7.2%
quarter on quarter annualised, compared
to the forecast quarter on quarter
annualised growth rate of 6%. This
represents the highest quarterly
advance seen in almost 20 years.
Major contributors to the exceptional
growth in the third quarter, which
were driven from a low base following
the Iraqi war, included: refinancing
activity, low interest rates and
tax cuts. It is interesting to note
that consumer spending was the largest
contributor - contributing some
4.7%.
While consumer spending has remained
resilient, this has been largely
as a result of fiscal and monetary
stimulus in the form of low interest
rates and tax cuts. The concern
going forward is whether this consumer
resilience is sustainable in view
of the fact that, while consumers
may have continued to spend, their
confidence levels have remained
low. Consumers are expected to receive
another "push" during the first
half of next year when larger than
anticipated tax refund cheques are
likely to be received. This is due
to the fact that the tax cuts were
made retrospective to the 1st of
January, but withholding tax only
being charged for half the year,
resulting in these refunds reflecting
the lower tax rates for the full
year. The best boost that consumer
confidence could get at this point
(and consequently consumer spending)
would be if firms began hiring again.
During the quarter exports improved,
supported by the weaker US Dollar,
while import volumes eased.
As anticipated in our last report,
the European Central Bank reduced
interest rates sharply at their
meeting on June 5th in an attempt
to stimulate sluggish business activity
in the Euro-zone. Rates are currently
at 2%, following the recent 0.50%
reduction, with further cuts expected
during the second half of this year.
The firm Euro (largely as a result
of US Dollar weakness since early
last year), which continued to impact
negatively on exports from the Euro-zone,
has also served to weaken corporate
profits in the region. The Euro
ended the quarter under review at
1.10 to the US Dollar, which is
softer than at the previous quarter
end (1.18) largely as a result of
weak growth in the region and amid
perceptions that the Euro-zone is
likely to lag the USA in a global
recovery. Economic activity has
been inhibited by the combination
of a firmer currency and comparatively
high interest rates for some time.
Inflation remains benign and within
the target range of below 2%. The
year on year consumer inflation
number for July was 1.9%. However,
deflation concerns in both France
and Germany persist.
The recent improvement in certain
data coming out of the USA has been
good news for the Euro-zone as there
is a view that, should a global
recovery be led by the USA, this
should serve to boost business sentiment
in the Euro-zone region, which in
turn should boost exports and encourage
new investment. Unfortunately, however,
because the US Dollar has depreciated
the most against the Euro (more
than 33% since last February), the
Euro-zone region has suffered the
impact of the weaker US Dollar the
most. The weaker trend of the Euro
against the US Dollar in recent
weeks should prove to be good news
for the region and its exports.
The Bank of England kept short-term
interest rates on hold at 3.5% following
their meeting on 6th and 7th August
2003, after having reduced rates
by 0.25% at their July meeting.
Rates are now at their lowest level
since January 1955. Rates were reduced
in July on the back of slower consumer
demand and a lacklustre global recovery.
Recent figures have indicated however,
that the UK economy is showing renewed
resilience.
Second quarter GDP growth, which
rose by 0.3%, was well below the
quarter on quarter expectation of
0.60%. This was disappointing, after
the first quarter growth numbers
indicated that the economy grew
at it slowest pace in 11 years.
Inflation is currently at 2.8%,
which is slightly above the target
rate of 2.5%.
In our last report we listed the
five economic tests that the United
Kingdom would need to pass in order
to join the Euro. In a statement
at the House of Commons in June,
Chancellor Gordon Brown stated that
the government's view was that only
one of the four tests had been met.
Accordingly, it is possible that
a referendum may be held next year
in order to decide the matter.
Despite facing many challenges,
the Japanese economy has begun to
show some resilience by expanding
0.6% quarter-on-quarter for the
second quarter, following a 0.30%
increase in the first quarter. It
is disappointing to note, therefore,
that the general view still appears
to be that the new governor of the
Bank of Japan has failed to action
policy initiatives of any significance,
in spite of being more flexible
on policy issues than his predecessor.
Notwithstanding the many economic
challenges, however, the latest
reading of the Tankan Survey (measures
manufacturing confidence) is the
best since March 2001. This increase
in capital spending and manufacturing
has given a long awaited boost to
economic activity. In addition,
the Japanese economy has benefited
from the increasing demand for its
goods by China.
Japan has also been a beneficiary
of the positive data starting to
emerge from the USA. The recent
improvement seen in the Japanese
equity market, which has helped
improve confidence, has been fuelled
to a large degree by foreign buyers
rebalancing the Japanese assets
in their portfolios. However, the
absence of both Japanese retail
and institutional buyers in the
market is apparent. As can be seen
by the movement in the Nikkei since
mid March this year, certain equity
stocks have delivered a strong performance.
Markets were surprised by the sharp
1.50% cut in domestic interest rates
by the Monetary Policy Committee
on 12 June 2003, with economists
largely having expected a 1% drop.
This was the first domestic interest
rate cut in 21 months, following
four 1% interest rate hikes during
the course of 2002. At the August
14th meeting, a further 1% interest
rate reduction was announced, which
was in line with expectations. This
brings the total reduction in short-term
interest rates to 2.5% in the last
three months.
CPIX, which came in at 6.6% year
on year for July was disappointingly
higher than the 6.4% year on year
figure for June 2003. This unexpected
rise in CPIX was brought about primarily
by the increase in food prices (7.5%
on an annual basis) and housing
costs (10.6% on an annual basis).
CPIX is currently close to the target
range of between 3% and 6% and is
still expected to fall for the remainder
of the year, despite the slight
increase in the July number. Furthermore,
while this should still leave the
Monetary Policy Committee room to
decrease short term interest rates
further during the next few months,
there is speculation now that the
extent and speed of the decrease
will be more gradual and that there
is a possibility that domestic interest
rates may stay higher for longer.
In the words of one economist "the
downward trend of the CPIX is being
slowed down. The likelihood of an
interest rate reduction of more
than 1% is decreasing". Domestic
growth for 2003 is expected to be
disappointing and has again been
revised down - the result of a firmer
currency, which has impacted on
exports, and high levels of inflation
that prevailed over the past number
of years. GDP growth for the second
quarter was a disappointing 1.1%.
During the first six months of 2003,
economic growth slowed to 1.5%,
from 3% during the last six months
of 2003.
During the quarter under review
(1 June 2003 to 31 August 2003),
the Rand strengthened against all
three major currencies ending the
quarter at R7.38, R8.11 and R11.66
to the US Dollar, Euro and Pound,
respectively. This was surprising
in that, a declining interest rate
environment in South Africa has
often (but not always - remember
1998 following the Asian crisis)
been accompanied by depreciation
in the Rand. In the current environment
of relatively high domestic interest
rates compared to the United States
and Europe, which has encouraged
a lot of foreign speculative investment
into the country to take advantage
of our high interest rates, it would
not be out of place to expect the
Rand to depreciate once our domestic
interest rates start falling, as
this serves to narrow the gap between
our interest rates and those in
the countries of the foreign speculators.
However, so far, this has not been
the case. A number of reasons could
provide the answer - firstly, domestic
inflation is once again under control
and the gap between our inflation
rate and that of our major trading
partners has narrowed. Other contributing
factors could include better growth
prospects for 2004 than 2003 and
the fact that overall policymaking
has been viewed as sound resulting
in South Africa being seen in a
more favourable light by the international
community. We must caution, however,
about the potential negative effect
that the weakness in the Euro-zone
economy (South Africa's largest
trading partner) could have on domestic
exports, with this region being
South Africa's largest trading partner.
In addition, the inflation outlook,
while currently positive, does have
certain risks. These risks include
high administered prices, recent
wage settlement rates of approximately
10% as well as a combination of
strong domestic demand with muted
domestic production.
A firmer Rand, however, is not
necessarily good news for everyone.
The export sector has been hardest
hit by the firmer currency and the
weakness in Europe, and this in
turn has served to slow domestic
growth considerably in 2003. Accordingly,
with exports on the decline, South
African imports on the increase
and with no real foreign direct
investment inflows evident, it is
only a matter of time before the
Current Account once again records
a sizeable deficit, if this trend
continues. There is a view that,
by year-end, the Current Account
deficit is expected to be in the
region of R11 billion, increasing
further in 2004. According to recent
statistics, the Current Account
recorded a deficit of 0.50% of GDP
in the first quarter. This could,
once again, put pressure on the
Rand and make the currency vulnerable.
The price of Brent crude oil increased
during the quarter to end the period
at $30.39 per barrel, from $26.51
per barrel at the end of the previous
quarter.
The gold price remained range bound
over the quarter - ending the quarter
at $376.50 an ounce, compared to
$365.95 per ounce at the end of
May 2003. The current upward trend
in the gold price began in early
2001 after the Federal Reserve began
its series of interest rates cuts.
The gold price has continued to
climb as USA short-term interest
rates have moved lower - low interest
rates make the opportunity cost
of holding gold low. In addition,
the current liquidity in global
markets combined with low short-term
interest rates and a weak US Dollar
have helped to sustain the gold
price at these higher levels.
In May 2003 we were pleased to
launch our website www.finlaw.co.za.
Following on from recent advancements
made to our website, clients will
be in a position to access their
personal portfolio details and fund
valuations directly from our website
via a secure process from the end
of August 2003.
Just a reminder to all farming
clients and those clients who have
second properties - the deadline
for obtaining valuations on your
properties is the end of September
2003. This valuation (which should
be a valuation as at 1 October 2001)
is not mandatory, but it is advisable
that it be done for possible future
Capital Gains Tax requirements.
On a final note, for anyone who
is in a dilemma about the amnesty
issue (both the income tax and exchange
control amnesties), think long and
hard about the consequences of not
applying. It is well worth doing
and a small price to pay for future
peace of mind. Ensure, however,
that you obtain the appropriate
advice for your personal circumstances
and that the application form is
completed correctly - you only have
one opportunity to get it right.
QUARTERLY QUOTE
"Don't try to buy at the bottom
and sell at the top. This cannot
be done - except by liars"
Bernard Baruch (My Own Story
- 1957)
This report is
based on information sourced from
various institutions, both local
and international. The report reflects
a variety of views and is not intended
to convey investment advice. Please
consult us to obtain specific advice
relevant to your investment portfolio.
