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.
UNITED STATES OF AMERICA |
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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.
EUROPE |
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.
UNITED KINGDOM |
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.
JAPAN |
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.
SOUTH AFRICA |
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.
GENERAL |
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.
CONCLUSION |
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.