Global Markets – 3rd quarter 2006 : Is the domestic interest rate party finally over?

Isn't it astounding how suddenly things can change? Although we hinted at a potential increase in domestic interest rates in our last quarterly report, most analysts were not expecting the interest rate increases to commence as quickly as they did. The Reserve Bank increased the Repo rate by 0.50% at their June meeting (the first interest rate increase in 45 months) and again by a further 0.50% at their August meeting, bringing the Repo rate to 8% and the Prime Rate to 11.5%. Although these increases are perceived as being "modest", upon closer inspection, the first interest rate increase translated into an "effective" increase of 4.76% in the Prime Rate, while the second increase represented an additional increase of 4.55%. All in all, these increases have translated into a total "effective" increase of some 9.31%. in the Prime Rate.

Most consumers are asking why interest rates have started to rise so soon, and what factors are fuelling the rate increases. Another much debated topic is by how much domestic interest rates are expected to rise during this current upward cycle? To answer the first question, we need to revisit the inflation target set by the Reserve Bank, which is between 3% and 6%. While inflation is currently within this target band, the Reserve Bank's inflation forecast indicates that inflation could breach the 6% upper level in the first quarter of next year. These rate increases are therefore seen as being pre-emptive rather than reactionary (hence the gradual increases). It is important to bear in mind that the effect of an increase in interest rates takes some time to work through the economy.

Factors that pose a threat to our domestic inflation target include the forecast of higher oil prices, a volatile Rand, the current account deficit, domestic credit extension as well as strong growth in domestic demand. Ongoing tensions in the Middle East and supply issues in the US continue to put upward pressure on oil prices. The Rand, which has been extremely volatile this year, is expected to remain volatile for the time being. The current account deficit has deteriorated markedly from last year, where the overall current account deficit represented 4.2% of GDP compared to 6.4% for the first quarter of 2006 (and is expected to remain at the 6% level for the second quarter of this year). Going hand in hand with this trend is our increased appetite for imports, which increased by 21.1% year on year for the first six months of 2006, while exports increased by only 8.6% over the same period. The increasing demand for credit by consumers continues unabated, as does the level of domestic demand, and it is hoped that the rising trend in domestic interest rates will place a dampener on these two areas. Taking into account the fact that domestic interest rates have been stable for the last four years, the sharp increase in the property market as well as the high returns delivered by our domestic equity market in what we can consider to have been a "stable" inflation environment, it is little wonder that consumers have developed an increasing appetite for credit and a higher demand for goods in general.

With these issues firmly on the Reserve Bank's radar screen, it is perhaps no surprise that they have called an end to the level interest rate "party" that has lasted for 45 months perhaps a little earlier than expected. While some will consider them to be "party poopers" for raising interest rates pre-emptively, we firmly believe that that they are currently administering the correct medicine to the economy. It is important that the potential inflation "headache" is treated well before it turns into a much-dreaded migraine. In order to achieve this, we expect that the Reserve Bank may need to "administer" at least another two 0.50% interest rate increases in this current upward cycle.

UNITED STATES OF AMERICA

After raising interest rates to 5.25% during the quarter under review, the Federal Reserve surprised the market by leaving interest rates on hold at their most recent meeting in August. However, the Federal Reserve have cautioned that interest rates could rise further if the economy starts to "overheat" or if inflation continues to increase.

Following 17 consecutive interest rate increases where rates have increased from 1% to 5.25%, this is the first time in two years that interest rates have been kept on hold. Commenting on this recent move by the Federal Reserve, one investment manager stated, "I think, clearly, the Federal Reserve is worried that the economy is going to slow down much faster than they would like." On the other hand, Shaun Osborne of Scotia Capital is of the opinion that "they are leaving the door open to a hike down the road. A pause as opposed to the end of the cycle." The difficulty being faced by the FOMC is that rising inflation is best addressed by raising interest rates, however, higher interest rates are likely to slow down economic growth.

GDP growth in the second quarter (to June) came in at 2.9%, which was ahead of the 2.5% forecast. However, this is still down from the 5.6% GDP growth recorded in the first quarter of this year.

The latest PPI (Producer Price Index) data released in mid August indicated that the July number increased by 0.1% - the lowest increase in five months. This was good news for the market, and confirms the FOMC's view that "it expected a slightly slowing economy to help restrain inflationary pressure." Jim Paulsen of Wells Capital Management commented on this number, saying, "PPI is good in the sense it doesn't necessarily say that the economy is weak, it just says prices aren't being passed on." The FOMC will no doubt keep a close eye on this PPI data, as PPI is generally considered to be a good early warning "signal" to imminent changes in inflation (CPI).

EUROPE

The European Central Bank (ECB) raised interest rates by 0.25% to 3% during the period under review. Inflation is currently at 2.4% (down from 2.5% in June), which is above the 2% target level. According to a European Commission report released recently, business confidence and corporate activity were at their highest levels since early 2001 in June. Analysts have hold the view that "this gave the ECB the space to raise rates by one quarter of a percentage point to tackle inflation without having to worry unduly about the knock on effect on business."

It is expected that inflation could well remain above the 2% target level into 2007, making further interest rate increases in the region likely. According to Jean-Claude Trichet (ECB President), the ECB will "continue to monitor very closely all developments to ensure price stability over the medium to longer term." The current view is that the ECB is expected to raise interest rates by as much as a further 0.50% (to 3.50%) before year end.

UNITED KINGDOM

In a surprise move, the Bank of England (BoE) increased interest rates by 0.25% to 4.75% during the quarter under review. This is the first change to interest rates in 11 months and the first increase in two years. Prompting the increase was the latest inflation number of 2.40%, which is 0.40% above the inflation target. Soaring oil prices and increasing energy costs are cited as being the main factors fueling inflationary pressures. The surprise increase in rates received a mixed reaction, with some economists believing that the MPC may have "jumped the gun", while others described the move as being "precautionary", with a view to averting further increases later this year.

According to the Office for National Statistics (ONS), growth during the second quarter to June was the highest level recorded in two years, boosted primarily by retail sales and a strong housing market. This is likely to have provided the MPC with sufficient scope to raise interest rates in an attempt to bring inflation under control, without impacting too heavily on the momentum of the economic recovery. However, if growth continues to come through strongly, this too is likely to generate inflation

Commenting on inflation, BoE Governor Mervyn King, has said "there remains great uncertainty about future energy prices, especially in light of political tensions in the Middle East, and inflation is likely to remain volatile over the coming months." He said that the MPC had chosen to raise rates "against a background of firm growth and limited spare capacity and with inflation likely to remain above target for some time. It [the MPC] remains ready to take whatever action might be necessary in the future."

JAPAN

The Bank of Japan (BoJ) raised interest rates to 0.25% in July, following zero interest rates in the region for almost 6 years (since March 2001). The motivation for keeping interest rates at zero for so long was an attempt to resurrect the economy and give it momentum after years of deflation. Zero interest rates encourage consumers and companies to borrow and to spend, making it less attractive for them to save. The BoJ have allayed consumer fears by stating that their adjustment to rates was likely to be "gradual". In keeping with this, no changes were made to interest rates at their August meeting.

Raising interest rates at this point is seen by some economists as being negative for Japan as a whole, as it will serve to remove liquidity from the economy. They believe that the BoJ may have acted too quickly, especially in light of the soaring price of oil and, while they are of the opinion that the prospects for the economy have improved, the "economic recovery is still finely balanced". This is despite the fact that the Japanese economy grew at an annualised rate of 0.8% for the quarter ending June 2006. Other economists believe that the move to raise interest rates should be welcomed, as it is a sign that "normality" is returning to the Japanese economy for the first time in more than a decade. The consensus view is that interest rates in Japan are "unlikely to rise more than once again this year."

The unemployment figures released for July were encouraging, with the unemployment rate down at 4.1% from 4.2% in June. Analysts were encouraged by this number, indicating that "the figures indicated a steady improvement in the labour market which should help lift the economy."

SOUTH AFRICA

At the time of writing the last quarterly article in May, the consensus view was that domestic interest rates were expected to remain level for the rest of the year. As a result, the pre-emptive 0.50% interest rate increase by the SA Reserve Bank (SARB) in June took the market completely by surprise. However, the next 0.50% increase in August was in line with expectations, with data at that stage clearly indicating that some warning signs in relation to inflation were beginning to emerge. The July inflation number came in at 4.9%, which is up from 4.8% in June. The main factors contributing to the increase in July include transport, housing, fuel, food and power costs.

Data supporting the SARB's interest rate increases, were the PPI numbers released for June and July. The June PPI figure jumped sharply to 7.5% (from 5.9% in May), while the July figure (released on the 31st August) increased to a shocking 8.1% year-on-year. This number was expected to remain the same as the June figure. As stated earlier, an increase in PPI is taken as an early warning sign that these price increases could filter through to the consumer. The latest PPI release points strongly to at least another two interest rate increases this year – at the SARB meetings scheduled to be held in October and in December. The latest trade deficit figure for July which was R7,746 billion, indicates that the current account deficit could be wider than first expected, and also supports the case for further interest rate increases.

The Rand, which has been remained volatile during the quarter under review, ended the quarter at R7.14, R9.17 and R13.60 to the US Dollar, Euro and British Pound, respectively.


GENERAL – OIL AND GOLD
While the oil price remained volatile during the quarter under review, it ended the period at $68.69 a barrel, compared to a close of $69.03 at the end of May. Increased conflict in the Middle East was the main driver of the renewed volatility, together with further supply issues in the US, where various pipelines had to be closed for maintenance.

In a recent statement, OPEC estimated that world demand for oil "is likely to rise more slowly than previously expected in 2006." They believe that the record oil prices (with oil having reached $78.40 a barrel in July) are likely to reduce demand. Another factor that could impact quite significantly on demand is the recent bomb plot on airliners travelling from Britain to the US, which are likely to have a negative impact on air travel. However, the report also indicates that "world tension and a strain on refineries may keep prices high, despite a rise in OPEC oil output and production capacity."

The gold price ended the quarter under review at $624.90 an ounce compared to $659 at the end of May. According to recent figures compiled for the World Gold Council by GFMS "identifiable investment demand for gold in the second quarter of 2006 increased by 19% in tonnage terms compared with the same period last year to 130 tons, driving the total value of investment demand for gold in the first half of this year up 40% to $6,1 billion." The gold price is up by more than 44% year-on-year from the end of the third quarter of last year.

CONCLUSION
We are delighted to confirm that Ashburton have again accepted out invitation to present to Finlaw clients. The presentation, which will cover topics such as international markets and trends, will be held at 17h00 for 17h30 at the Redlands Hotel on Thursday afternoon the 2nd November 2006. Invitations will be mailed out at the end of September. We know that you will find the presentation both topical and informative, and we encourage you to attend. You are also welcome to bring a guest.