We have all felt the impact of rising prices recently, most especially when filling up at the petrol station or shopping for groceries. This stands to reason as food and transport costs are the two largest components of the “inflation basket”, making up 28.62% and 15.20%, respectively. The next two components come as no surprise – housing (11.57%) and medical costs (7.70%). Naturally every household has different levels of exposure to these costs. Recent statistics indicate that 73.7% of South Africans have a household income of less than R4 400 per month, while almost 15% of these households live on less than R2 000 per month. These statistics go on to reveal that only 6% of the population have a monthly household income of more than R19 974. According to Fraters “the lower income households are also likely to spend a proportionately higher amount on food and transport, the two components of inflation that have shown the highest growth. These two components are also at the mercy of supply side dynamics, and consumers are forced to buy the same quantities, no matter what the price.”
It is reported that in 2006 less maize was planted following the maize surplus in 2005. Unfortunately, unfavourable weather conditions impacted on the maize harvest, resulting in the current maize shortage. And typically, a shortage in supply, translates into greater demand and higher prices. The price of maize has also risen internationally as maize is now being used in the production of bio-fuels. While food and fuel prices are high up on the list of culprits, we must remember that supply and demand factors also impact on inflation. By way of example, recent wage disputes have resulted in settlements for annual increases at levels above inflation. In terms of the “supply” side, uncontrollable factors such as the weather and world prices have impacted negatively on the price of raw materials and fuel. All these factors contribute to inflationary pressure.
We know that inflation has breached the upper target (6%) for several consecutive months, and this has become a cause for concern. Consequently, the Reserve Bank have again raised interest rates at their June and August meetings. The latest inflation figure came in at 6.5%, which is higher than the projected 6.2%.
What can be done to curb this rising trend in inflation? The answer to this type of question is never simple because there are so many factors at play. According to a recent article published by Fraters, “for overall inflation to decline in an environment where food and fuel prices are rising faster, we need the rest of the basket to show some price declines.” Consumer spending also needs to slow further. The environment of higher interest rates and the new stringent requirements put in place by the National Credit Act in June should put a dampener on spending. In the meantime, there is already evidence that consumers are starting to feel the pinch and, as a result, are likely to think twice about increasing their already onerous debt levels. In turn, slower domestic demand should serve to moderate price pressures. However, we may not have turned the corner just yet. It looks like we may well be in for another interest rate increase in October based on the disappointing inflation and producer numbers released at the end of August.
Source: Fraters quarterly report – 2nd quarter of 2007 and various publications
UNITED STATES OF AMERICA
The Federal Reserve kept interest rates unchanged at 5.25% during the quarter under review. This is the ninth consecutive meeting over a thirteen month period that rates have remained level. Commenting after the announcement, the Federal Reserve stated, “financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.” Their statement went on to state that” although the downside risks to growth have increased somewhat, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.” However they expect the economy “to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.” Economists are divided as to whether the next move in rates is likely to be up or down. The prevailing view is that the next move could well be down, but that this is unlikely to happen anytime soon. Second quarter GDP figures have been revised up to 4%.
Concern over credit in the US, particularly in the US sub-prime mortgage market which led to the re-pricing of risk in the credit markets, sparked volatility during the quarter. “Sub-prime mortgages are higher-interest loans given to higher-risk borrowers or those on low incomes.” Consequently, sustained periods of “high” interest rates are likely to impact on these borrowers first. In a surprise move on the 17th August, the Federal Reserve “cut its primary discount rate, which is the rate at which it lends money to banks, from 6.25% to 5.75%.” Commenting after the announcement the Fed stated, “financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward.” The Federal Funds Rate has remained unchanged at 5.25%.
After raising interest rates to 4% in June (in line with expectations), the European Central Bank (ECB) left rates on hold for the remainder of the quarter under review. The latest increase takes rates to their highest level in 6 years (after doubling in the last 18 months). Commenting after the July meeting, Jean- Claude Trichet said, “our monetary policy is still on the accommodative side, with overall financing conditions favourable, money and credit growth vigorous, and liquidity in the euro area ample.”
The market still expects further rate increases in the region later this year, which have been reinforced by ECB President Jean-Claude Trichet’s promise of “strong vigilance” when it comes to dealing with inflation. Despite inflation currently being below the 2% target at 1.8%, robust growth in the region is likely to put upward pressure on inflation. Strong credit demand by the private sector remains an area of concern for the ECB, with recent statistics indicating that loans in this sector have increased at their fastest pace since December 2006 – up by 10.8% for the one year to June.
The Bank of England (BoE) increased interest rates by 25 basis points to 5.75% at their July meeting after commenting that “most indicators of pricing pressure remain elevated.” Rates remained unchanged at the August meeting of the BoE, bringing an element of relief to borrowers who have experienced 5 interest rate hikes in the last year. Senior economist of the EEF (the manufacturers’ organization), Lee Hopley, welcomed the August decision to leave rates on hold, saying that “given some evidence that the Bank may already have done its job, rates should now be left where they are until a clearer assessment can be made of the direction of the economy.”
David Kern, economic adviser for the British Chambers of Commerce agreed, saying “we remain very concerned that the markets still expect an increase in rates later in the year. There are already signs that the housing market is softening. The slowdown in average earnings growth strengthens further the case for waiting.” He went on to add that “disposable income growth is at record lows and savings levels are also very low.”
In mid August, the July inflation figure came in at 1.9%, which was well ahead of expectations and significantly better than the June number of 2.4%. Inflation has stubbornly remained above the 2% target level and this is the first time since March 2006 that it has dipped below 2%. Commenting on this good news, Howard Archer of Global Insight said, “this is a massive surprise. Consumer price inflation fell back far more than anyone was expecting in July, including, we strongly suspect, the Bank of England. This will boost expectations that interest rates have peaked at 5.75%, especially as the current turmoil in global credit and financial markets further dilutes the case for higher interest rates, at least for now.” According to a BBC report “the lower cost of food – from bread and cereals to meat, fish and fruit – was the biggest contributor to the surprise fall in consumer price inflation as supermarkets slashed prices to compete for market share.” Lower energy bills and discounts offered by furniture retailers also added to the lower than expected inflation number. In the same report the Office for National Statistics has warned, however, that the recent flooding could “cause supermarket shortages in the run-up to Christmas, which would in turn push up the price of food, particularly vegetables and milk” Before this data become available, it was widely expected that interest rates would rise to 6% by year end.
In line with their forecast, Nationwide have reported that growth in house prices “stalled” in July, and is a sign that higher interest rates are starting to impact on buyers. It is reported that the annual rate of growth declined to 9.9% in July from 11.1% in June. Commenting on the slowdown, Fionnuala Earley – the chief economist for Nationwide, said “the sharp slowdown in July’s house price numbers could show that potential homebuyers are thinking twice about overstretching themselves in a higher interest rate environment.”
The Bank of Japan (BoJ) left interest rates unchanged during the quarter under review, having last increased rates from 0.25% to 0.50% in February. The market had expected rates to rise again in August, but the BoJ elected not to do so in the “wake of recent turmoil in financial markets worldwide”, a BBC article reported. In addition, economic growth figures for the second quarter to June came in below forecasts at 0.1%, compared to the market expectation of 0.2%, primarily as a result of “lacklustre exports”. Rates are still expected to rise later this year, but at a gradual pace, due to the fact that inflation is still non-existent in the region.
Unemployment in Japan recently recorded 9 year lows. As highlighted in our last report, improving employment levels are having a positive impact on consumer confidence, and as a result, an improvement in consumer spending is becoming evident.
At the end of July, Prime Minister Shinzo Abe’s ruling partly lost its majority in the upper house following the first “nationwide electoral test since he took office 10 months ago pledging to boost Japan’s security profile and rewrite its pacifist constitution.” According to a recent article by Reuters, “Abe’s coalition will not be ousted from government by a loss in the upper house, since it has a huge majority in the more powerful lower chamber, which elects the premier. But with the main opposition Democratic Party of Japan on track to become the biggest party in the chamber, laws will be hard to enact, threatening policy deadlock.”
In line with expectations, the Reserve Bank (SARB) raised domestic interest rates at both meetings during the quarter under review. As a result, the Prime Lending Rate and the Repo Rate have increased to 13.5% and 10%, respectively. The latest increase is the sixth interest rate increase since June last year, with rates having risen by 3% in the current tightening cycle. Although the latest announcement was widely expected, it was received with some criticism in light of the market turmoil which is attributed to the sub-prime mortgage market in the US. According to Colen Garrow, chief economist at Brait, “I think the decision is one that introduces negative risks. I think it shouldn’t have been about adjusting rates today – there may have been a more appropriate time to hike rates. The key central banks are standing by their markets by providing support, but today’s decision doesn’t do that for South Africa.”
Stats SA reported in late August that GDP growth for the second quarter came in at 4.5% (quarter-on quarter) compared to 4.7% in the first quarter of 2007. It is reported that the business services industry, finance and real estate were the main contributors to growth in the second quarter.
The July inflation figure of 6.5% year-on-year, announced at the end of August, came as a nasty surprise. Most analysts had expected a figure of 6.2%, which is slightly below the 6.4% recorded in June. The July Producer Price Inflation (PPI) figure was also disappointing at 10.3%, which is marginally better than the 10.4% level recorded in June. The market had expected this number to come in at below 10%. As a result, there is now a strong likelihood of another 50 basis point increase in interest rates in October..
GENERAL – OIL AND GOLD
The oil price remained volatile during the quarter under review, ending the period at $72.20 a barrel, compared to $67.89 a barrel at the end of May. During the quarter under review, the price reached $78.77 a barrel, following continued concerns about disruptions to supply particularly in the North Sea and in Nigeria. Adding to these supply concerns was the worry that demand could well outstrip supply by the end of 2007. However, prices declined in early August. Commenting on the price decline, Gerard Burg, an oil and gas analyst from the National Bank of Australia, stated “the sell-off was continued from Friday and largely due to the decline in the US financial markets. Some investors may have taken risk adjustments and are selling out of liquid commodities assets to cover commitments in other markets. Apart from the US factor, there are no major fundamental stories dragging down prices.” Goldman Sachs have indicated that they expect demand for oil to remain the same, and that this demand will be driven largely by emerging markets.
The gold price experienced periods of volatility during the quarter, ending the period at $673.25 an ounce, compared to a close of $660.55 at the end of May. Typically when there is an element of market volatility (as was the case during the quarter) investors tend to move towards gold as it is seen as a “safe haven”. It is worth noting that investors don’t appear to have done so this quarter, with risk aversion in the equity markets also spreading to commodities.
We are pleased to confirm that the presentation by Sarasin to clients of Finlaw will take place at the Redlands Hotel on Thursday the 20th September. The seminar will start at 17h00 for 17h30 – invitations were mailed out on the 20th August. Should you wish to invite a guest to the presentation, please let us know by the RSVP date detailed on the invitation.
Finally, a reminder about the deadline for the submission of personal income tax returns, which is 31 October 2007.
“The human race has one really effective weapon, and that is laughter”