Putting inflation into context
South Africa recently experienced one of its lowest year-on-year inflation rates of 2.1% in May 2020. This is well below the average annualised inflation rate of 5.4% since 2008 and minimum level of the South African Central Bank’s target inflation band of 3%.
The fall in inflation rates comes as no surprise after the country was placed into lock-down and economic activity, measured by gross-domestic-product, fell by -51% during the second quarter of 2020. Other factors such as the oil price have contributed to keeping inflation levels down despite a weakening Rand. Brent Crude oil prices fell below $30 a barrel during March from $66 at the start of the year and are currently trading close $40.
In response to the onset of a slowing economic environment, government and central banks across the world have acted quickly to maintain liquidity in their financial systems. They have supplied trillions of dollars into financial markets through a combination of expansive monetary policy programmes and fiscal relief programmes. Economic theory suggests that inflation is created when the level of money supply, controlled by central banks, increases to levels in excess of the spending needs and demands of consumers and business (demand for money).
Given this backdrop, one of the big questions facing investors today is whether the stimulus programmes will lead to higher inflation rates in the future.
In tackling this question for South Africa’s inflation rate, it is necessary to understand which goods and services are tracked in the inflation basket, how each category has contributed to the inflation rate historically and what categories in the basket are expected to drive inflation rates into the future.
Unpacking the South African Inflation Basket
Using data from the Living Conditions Survey, as well as from other sources, Stats SA identifies products and services that households spend the most money on, and these form the basket of goods. The SA inflation basket consists of 412 goods and services. These items are then aggerated into 12 broad categories that are presented, along with their weights, in the chart below:
The top 4 categories comprise 71% of the inflation basket. Individual items that dominate the inflation basket include housing costs (15% basket weight), food (17%), health insurance (8%), vehicle purchase costs (7%), utilities (electricity & water) (7%) and fuel (4%).
What categories have driven inflation in the past?
We looked at the growth of each category’s price level since January 2008 and plotted the change in monthly prices on a graph to see which category of the basket have seen the greatest rise in price level. The growth of each category in the basket is shown in the chart below:
We found that the price levels of 7 of the categories (70% of the basket) grew faster than the SA Consumer Price Index (CPI) Basket since 2008, which increased on average at 5.4% per annum (p.a.). The standout category’s that showed the highest increases to their price levels included Education, Alcoholic Beverages & Tobacco and Miscellaneous Goods & Services.
In each category, we looked closer at the price items that drove the evolution the price increases (the growth rates shown are the compounded annualised growth rate or average annual growth rate):
• Education (2.3% basket weight): the increase in prices were felt across the entire system including primary/secondary education, which grew at an average rate of 8.8% p.a. and tertiary education (e.g. universities) which grew at 7.2% p.a.
• Miscellaneous goods and services (14.8%): the rising cost of health insurance which grew at an average rate of 7.6% p.a., drove most of the increases to price levels in the category, while routine medical services grew of 6.9% p.a.
• Food and non-alcoholic beverages (19.2%): food items across the board saw increases to their price levels mainly through rising meat & dairy products prices of 6.0% p.a. and sugary food at 8.4% p.a., while prices for vegetable and fruits grew at 5.2% p.a.
• Housing (16.0%) and utilities (6.6%): prices were driven by increased electricity prices (3.8% basket weight), which had an average growth rate of 11.9% p.a., almost double the SA CPI inflation rate. This was offset by the lower growth rates of equivalent rents (implied rents of owned house) and actual rental costs (15.1% basket weight) which only grew by on average 4.8% p.a.
The categories that grew below the SA Inflation Basket price increase included transport, clothing & footwear, recreation & culture, household contents and communication. The items that were the biggest detractors from the inflation rate of the categories are commented on as follows:
• Transport (14.7% basket weight): experienced an average growth rate of 4.0% p.a. The main driver within Transport were vehicles purchase, which had an average growth rate of 2.8% p.a. compared to fuel and running costs, which increased at 5.9% p.a.
• Recreation & culture (4.9%): although restaurants, hotel and book prices grew at an average rate above 6% p.a., they were offset by the slow pace growth of recreational services (cinema, concerts, sport events) of 4.3% p.a. and sports equipment of 0.2% p.a.
• Household contents (4.3%) and clothing & footwear (4.0%): other items of interest that kept inflation low were discretionary goods such as appliances and furniture in the category that grew at 2.2% p.a. This was accompanied by the relatively slow price growth in Clothing and Footwear of 4.0%.
• Communication (2.6%): this category experienced deflation (price level decreased) mainly as a result of the -13.2% average annual decrease in postal services and telecommunications.
The South African Reserve Bank (SARB) targets an inflation rate of between 3-6%, which has been in place since 2000. At the SARB’s monetary policy meeting on the 17th September, the forecast a headline SA inflation rate of 3.3% for 2020, 4.0% for 2021 and 4.4% for 2022. Most commentators agree that the recent slowdown in the inflation rate will be temporary and set to recover during the second half of 2020 and into 2021. The obvious headwind to this view is the possibility of a 2nd wave of Covid-19 that could cause further economic slowdown.
The inflation rate has already increased to 3.2% July 2020 from its lows in May, but this is still close to the bottom of the SARB’s range and well below the average annual rate of 5.4% since 2008. If we believe that that inflation will revert up to the 4-4.5% levels over the next 2-years, which is forecast by the SARB, what categories in the inflation basket are likely to drive this increase?
To answer this question, we split the inflation basket into two categories based on whether they have been historic inflation drivers (above SA CPI average growth) or inflation detractors (below SA CPI average growth). Then we compared the historic inflation rate to the inflation rate shown in the latest print available at the time of writing being the end of July. Assuming a level of mean reversion in the inflation rate albeit to a lower rate, those categories with the greatest deviations from their average are considered potential drivers of future inflation. The chart below displays the divergence:
The historic category ‘outperformers’ continued to grow at above the CPI rate in July albeit at a 2.2% lower rate in weighted terms than historically. The two biggest categories making up 41.8% of the basket, food & non-alcoholic beverages and housing & utilities, appear to be most obvious sources of future inflation, having seen inflation rates fall by more than 2% from their 12-year annual average. The exceptions to above average inflation rates were the categories which were hardest hit during the lockdown being alcoholic beverages & tobacco and restaurants & hotels.
In terms of the historic category ‘underperformers’, they too experienced decreases to their inflation rates across the board with a weighted fall of 2.6%. The worst hit category was transport, being 3.7% below the 12-year average annual inflation rate. This was largely driven by fuel price decreases which fell 6.2% versus last year July’s price and private vehicle transport that fell by -4.1% over the period. Any recovery in prices in this category, particularly if oil prices increase, will impact the overall inflation rate, given the transport category weight of 14.7% in the inflation basket.
Best of Breed™ Investment Managers’ Inflation Outlook?
We spoke to several of the Best of Breed™ managers and discussed their inflation expectations. Their answers are summarised below:
Rashaad Tayob – Nedgroup Investments Flexible Fund
In terms of our inflation outlook, we have amalgamated the forecasts of 4 economists who we believe to me most credible in the domestic space. They see inflation normalising next year to remain above 4%. We are in a period of elevated uncertainty, due to SA's economic conditions, and the effect of the pandemic. The range of scenarios that can materialise next year are therefore much wider than they were historically.
Despite the weak economy, we do not believe inflation can be sustainably below 4%, as administered prices are sticky, and our economy remains relatively uncompetitive, which necessitates a weaker exchange rate over time. This is expected to place pressure on the inflation rate.
In this environment, inflation linked bonds are an attractive position in the Nedgroup Investments Flexible Income Fund, especially given where the nominal yields of these bonds are trading as well as the inflation protection provided by the instruments.
Iain Power – Nedgroup Investments Balanced Fund
The effects of demand weakness induced by Covid-19 are likely to be deflationary over the next few years. However inflationary expectations are already very low, and we think the unprecedented policy measures undertaken by central banks to support the global economy will begin to put upward pressure on inflation expectation especially once a vaccine is announced.
We think post a vaccine there would be a significant amount of pent up demand which would be unleashed pushing up inflation expectations. From a cyclical perspective, as the global economy recovers, we expect the US dollar to weaken and commodity prices to rise which will add to this pressure. The positioning in platinum and oil stocks in the Nedgroup Investments Balanced Fund are expected to benefit from this environment.
De-globalization is ultimately bad for corporate profitability and is also inflationary and will at the margin add upward pressure to prices in general over the next decade. In addition to the above, global central banks have said they are prepared to let inflation run a ‘little hot’ before they respond with tighter monetary policy and this increases the probability of inflation moving up over the medium to long term.
Dwayne Dippenaar and Brian Thomas – Nedgroup Investments Growth Fund
Inflation in the retail sector can broadly be broken into three distinct categories: food, drug and apparel. Food inflation as measured through the tills of the food retailers, as opposed to the inflation calculations produced by Stats SA, has averaged 3.4% over the first half of 2020, and the outlook is that it may tick up slightly from this level, to around 4-to-4.5% next year.
Food inflation is the friend of the food retailer and higher food inflation helps cover some of the increasing fixed costs associated with running these businesses, mainly in the form of wages and rentals.
Woolworths Foods has registered the highest price inflation in the first half of 2020 at 8%; Shoprite’s South African operations are running at around 3.4%. Woolworths with higher food inflation and gaining market share in the food space is a clear differentiator for them.
In the drug sector which is dominated by Clicks and Dis-chem, inflation has averaged around 2%. This is mainly driven by single exit pricing regulations which govern the price that these retailers may charge for dispensing medication.
In the apparel segment the inflation drivers are somewhat different. Whilst input costs have increased on imported garments due to a weakening Rand, there has been an offset with most retailers running sales to reduce stock that needed to be cleared post Covid-19 lockdown. This has led to a drop-in inflation of around 3.5%. It is expected that as trading returns to normal so too will inflation and will probably normalise around the 4% mark going forward.
Over the short-term, we have witnessed a slowdown in inflation rates, but this is expected to reverse in the medium to long term as economies move out of various lock-down restrictions and begin to digest the increased lower interest rate environment. There is a big ‘if’ attached these outlooks, given the possible and probably impact of a 2nd wave of Covid-19 cases.
However, Rand weakness, rising oil prices and rising commodity prices, including food, are all expected to impact the price levels of the inflation basket. Our managers expecting South African inflation rates of between 4-4.5% over the medium term, which appears broadly in line with the SARB’s outlook.
Central banks and governments have embarked on economic stimulus programmes to help economies navigate the disruptions caused by Covid-19. In this low growth environment, central banks are unlikely to respond to rising levels of inflation through significant monetary tightening and interest rates are expected to remain low.
In anticipation of this environment, investment managers mentioned in the article have positioned their funds with higher allocation to inflation-protecting assets such as inflation linked bonds and commodities. They have also, where necessary, focused on retail businesses which possess pricing power to negotiate with suppliers or pass on higher costs to their customers.