Bottom Line: In line with expectations, the SARB hiked for the second consecutive meeting, and all indications are that this is the start of a trend that will persist throughout the year. Only if the data begins to soften will the SARB reassess the economic outlook in favour of pausing; however, there is much to take into consideration. Internationally, central banks around the world are hiking, and the SARB will not want to be out of step with them lest it leaves SA exposed to a ZAR blow-off. Domestically, however, the economy is weak and the credit cycle soft. It is not the kind of environment that would result in runaway inflation. Should inflation domestically prove transitory in line with SARB expectations, the more hawkish estimations of interest rates could very well moderate.
BASELINE VIEW: SARB guidance suggests that each meeting hold rate hike risk with 25bp of hikes for the foreseeable future, which would take up another 200bp. However, one should not forget that the QPM has been wrong in the past as it formally hinges on expectations for various inputs that are ultimately unpredictable. Weak growth will challenge the outlook, while ZAR weakness would raise the probability of rate hikes, which is why the current ZAR vulnerability may embolden the SARB to do more.
In Line with expectations, the SARB hiked rates for the second successive meeting. It was in line with expectations and is a direct response to the rise in the inflation rate to the top of the inflation target range.
Against the backdrop of supply chain constraints, rising oil prices, volatility in financial markets and the ZAR, the SARB had little choice but to take pre-emptive action. The hope is that acting early, could save the SARB from having to take more drastic action later on.
The risks at the moment is that doing nothing, would leave the SA economy vulnerable to a possible inflation spike that could undermine what remaining growth dynamics the SA economy enjoys. The probability is now high that the SARB will look to hike more through the months ahead, with the next chart highlighting the risks.
What was significant about the latest MPC meeting is that interest rate expectations moderated. It meant that the signals and communication that came from the SARB at this meeting were a little more dovish than many had anticipated and that investors priced out the risks associated with more aggressive rate hikes.
That is not to say that more rate hikes are no longer anticipated. Merely that the degree of tightening has been reassessed. The risk of a larger than 25bp rate hike at the next few meetings has been priced back out. It appears as though the market got a little bit ahead of itself and is now pricing in a more realistic scenario.
From a ZAR perspective, that detracts from the ZAR's resilience given that short-term rates have retreated and bonds yields have not risen as they might've in an environment of rising inflation and monetary tightening.
Repo Rate Remains Accommodative
For all the hiking and the expectations of more to come, it is also worth noting that even with a string of rate hikes, that monetary policy might still be considered accommodative of growth. Even if one were to look at a hawkish scenario where the SARB acts more aggressively, maybe due to weakness in the ZAR, a much higher oil price or both, monetary policy would still be supportive of economic growth.
There are several reasons to think that SA's structurally fragile economy could underperform its potential in coming years, with business investment levels exceptionally weak. Inflation risks were nevertheless assessed as being to the upside, mainly owing to administered prices and energy. The bank's forecast nevertheless suggests that inflation will have peaked in Q1, moderating in 2022 from an average of 5.6% in Q1 to 4.3% in Q4.
Note that despite weak growth and moderating inflation, a higher rate outlook persists due to real interest rates being deeply in negative territory. The quarterly projection model (QPM) assumes a "neutral real rate" of 2.3% for the next two years and a CPI assumption of 4.3% in Q4 (4.6% for 2022 as a whole), suggesting that rates could rise to 6.6% (2.3% + 4.3%) by the end of 2022 while still being assessed as accommodative. Despite an effective target of 6.6%, the QPM's cognition of growth risks was represented in its repo rate forecast, which was downwardly revised to 4.91% by the end of 2022. This suggests that rates will remain in accommodative territory by nearly 1.7 percentage points.
The Q4 2023 average inflation assumption of 4.6% y/y suggests that the bank considers 6.9% to be the "neutral rate" target for 2023. Therefore, its repo rate forecast of 5.84% by the end of 2023 also remains reflective of sub-optimal growth conditions. Kganyago again highlighted that the QPM forecast was but one input into the SARB's decision process, suggesting that policymakers remain ready to manoeuvre in accordance with a range of factors not necessarily reflected in the model.
ZAR Weakness and Inflation
When growth in money supply is high, there is plenty of monetary space to accommodate both demand for credit, as well as inflationary pressures. Under these conditions, the two would coincide and so called "demand pull" inflation would become a theme. The weaker growth in money supply is, the less it accommodates the combination of the two.
It is therefore fair to say that the weaker the growth in money supply, the less room there is to accommodate inflation, and that tends to be associated with weaker demand for credit. In recent years money supply growth rates are roughly half of what they were, and the top half of this chart therefore shows that there is less sensitivity of inflation to the depreciation of the ZAR.
Although a weaker ZAR will inevitably raise the risks of inflation to the topside, it may not translate into a strong inflation episode, unless the demand for credit rises significantly. That is unlikely in a tightening monetary policy environment that should help keep inflationary pressures contained. Any breach of 6% will be temporary.
Of course, that assumes that there is no major collapse in financial markets that prompts a strong rotation towards safe haven assets such as the USD. Were that to happen, the weakness in the ZAR that would follow, could cause a temporary, but painful and significant inflation shock to which the SARB would need to respond. This is not the core scenario for now, but is something investors need to keep a lookout for.
For now, the more contained inflation picture will count against the ZAR in the near-term as investors position for a more accommodative SARB. However, the outlook is fluid and can change as developments in financial markets unfold.
Labour Market Remains Weak
The country's labour market data currently makes for grim reading as it becomes more concerning with every iteration released. The official number of employed individuals dipped 660k persons in Q3 compared to Q2 to take the number of employed down to 14.3mn or less than 25% of the 60mn-strong population.
This suggests that the jobs market is under considerable pressure, while the upside pressure on the unemployment rate has been masked by a rise in the number of discouraged work-seekers. The report showed that while hiring increases occurred in the informal sector (9k) in Q3, job losses were sustained in the formal sector (571k), private households (65k) and agricultural sector (32k). This suggests that consumer demand could be significantly constrained going forward and that the retail sector could be subject to further downside pressure on volumes.
The Quarterly Employment Survey that was released earlier this month meanwhile showed that the labour market remains in an environment of constrained income, perhaps providing some evidence to support the view that bank lending is likely to remain conservative for some time.
Not only does this impact overall growth levels of the economy, but it constrains government tax intake, something that cannot be afforded right now given that there is constantly increasing pressure for additional spending on social programmes. This fiscal constraint is reflected in the steepness of the SAGB yield curve, and until such a time when major reforms are implemented, the longer-term bias for the curve will remain one of steepening.
Inflation Risk Remains Relatively Benign
In recent months, headline inflation has been accelerating, following the global trend amid higher fuel and food prices. In December, inflation rose to 5.9%, the fastest pace seen since early 2017. Although not overly concerning given that it remains within the SARB's target range and is roughly in line with the SARB's forecast for inflation to peak below 6% in early 2022, the SARB has assessed the risks to inflation to be to the topside and has moved to pre-emptively hike twice.
While supply-side inflation risk remains a concern, the risk of this stoking broader inflation pressure is limited given a weak macroeconomic backdrop. Given low M3 money supply growth of around 6.3% y/y recorded in November, there is limited monetary space for inflation to take hold. Supporting this is the fact that retail volumes also remain suppressed, with the "constant price" level of sales in November still around 2% below the pre-crisis trend. Prior episodes of higher inflation have followed money supply growth rates of more than double where we currently are, and a high level of consumer demand. To this point, note that core inflation (which excludes food and fuel inflation) has risen slightly to 3.4% y/y, not far off the lower limit of the SARB target range.
While the headline figure is expected to remain buoyed amid elevated oil and food prices in the months ahead, an environment of tight monetary conditions and weak economic growth suggests that core inflation will be relatively well contained. Moreover, in-house indicators such as ETM's inflation risk index suggest that while inflation could quicken in the near term, consumer prices are expected to moderate in the first half of 2022, partly due to base effects. In terms of the SARB, the central bank will seek to raise or normalise interest rates by hiking by incremental 25bp rate hikes unless incoming data turns soft and forces them to pause.
Growth Outlook Supports Lower Rates
Alongside the constrained domestic credit cycle, is also the level of fixed investment which also plays a significant role in driving demand for imports. As is clear from this chart, fixed investment has been on the slide and while there are some signs it is stabilising, it is doing so off a very low base, where demand more broadly remains heavily constrained.
South Africa's growth trajectory is looking weaker compared to estimates made earlier this year, with the most recent GDP numbers confirming this. The economy expanded by only 2.9% y/y in Q3, even with significant base effects at play. This suggests that the final figures for 2021 will be around 0.5pp lower than the 5% that many had expected, with the risks to this skewed even further to the downside now given the incessant loadshedding experienced in Q4, coupled with the damage to the tourism and hospitality sectors that the travel restrictions will have done.
A worrying theme emerging from the Q3 data was weak investment. The data showed that non-government gross fixed capital formation remains depressed relative to historical norms, which suggests that future growth potential will be constrained as fixed capital generates future growth in the productive sector. This suggests that the low growth theme that has emerged since the lockdowns remains entrenched, with low investment and a weak recovery suggesting that the risk of a double-dip recession remains in place. The upside to this is that a weak growth environment gives the SARB room to remain accommodative in its monetary policy stance
Given the weak growth environment and a ZAR that remains fragile amid a host of structural hurdles, we have used the SARB’s model forecasts to estimate where rates could potentially go in two differing scenarios: one where the USD-ZAR experiences significant depreciation pressures and another where growth underperforms expectations.
If the ZAR were to come under considerable pressure, the SARB would be forced to hike, barring a significant collapse in growth, with forecast assumptions from the SARB suggesting that rates could get as high as 7% by the end of 2022.
At present, we believe this is unlikely given the low growth and limited investment outlook. Weaker than expected growth outcomes could see rates stabilizing closer to 4.5%.
After initially front-running the SARB before the November MPC meeting, the market now seems to be doubting SARB guidance, pricing out significant rate hike risk over the coming two years. At this stage, despite high levels of administered price inflation, there is limited reason to think that notable second-round inflationary pressure will materialise.
Over the 12-month horizon, the market currently expects 125bp worth of rate hikes, slightly more hawkish than what the SARB's model predicts, but we could see this moderate if the ZAR remains resilient and exogenous factors such as oil and other commodity prices continue to come off their highs
ZAR Sentiment Indicator Neutral at the Moment
Last but not least, ZAR sentiment deteriorated slightly after the MPC decision. Although it is not clearly visible in the accompanying chart, the higher frequency ZAR Sentiment line (light grey) ticked lower and back to neutral territory. In the coming weeks, it will be interesting to note whether this line dips back into depreciation territory.
This might offer some perspective on whether the SARB has done enough to avoid a bout of volatility in the ZAR, or whether it has a lot further to hike. Early indications are that the current two hikes are far from sufficient.
That being said, this data also highlights the expectations of the professional ZAR market and that traders do not anticipate a major blow-out in the ZAR from current levels. It will be an interesting few months ahead as the world comes to grips with an unwinding of ultra-accommodative monetary policies, one that could usher in a fresh period of uncertainty and lack of clear directional momentum.