By Cees Bruggemans, Chief Economist FNB
01 November 2010

Our recovery prospects continue to be reinforced by daily data, promising a yet stronger foundation for what lies ahead.

CPI inflation surprised yet again by dropping to 3.2%, the lowest in seven years, possibly still not the lowest in this cycle.

Ever since early 2008, inflation expectations for October 2010 fluctuated in a 5%-6% range, even as late as January 2010. Thereafter forecasters gradually capitulated as the realization finally sunk in that something fundamental was happening, inflation surprising on the downside every month.

By August the expectation for October's release was down to 4%. But this was still not enough of a revision, given the final reality of 3.2%.

Also this past week PPI inflation surprised hugely. Instead of being 8% as expected, it undershot at 6.8%, indicative the inflation impulse is weaker than thought.

Along with only modest growth, heavy job losses and limited job gains given good productivity gains, this increasingly created scope for interest rate cuts, far beyond even what the SARB ever expected.

Already 18 months ago, SARB Governor Mboweni thought he had discerned the low point in the rate cycle. And after a few more cuts, SARB Governor Marcus thought a year later she had also arrived at the cyclical low point.

But as global events marched on, steadily pushing the Rand firmer, our inflation was grinded ever lower.

Not only imported inflation, but also second round electricity effects and even nominal wage demands compensated with job losses, as domestic slack and delayed expectation adjustments made for the downside.

And still we aren't apparently at the end of it all, with the market last Friday at one stage discounting 100% probability of another 0.5% rate cut shortly.

All this has done wonderful things for the complexion of our asset markets.

Government bonds have benefited from lowered inflation expectations, as foreign investor appetite has been further wetted by still high returns, with further Rand appreciation as sweetener, an irresistible combination for many.



Equity investors have been tempted by our recovering growth and prospects. Also, by company ability to contain costs and achieve productivity gains, like overseas ensuring a strong cyclical rebound in company earnings.

Thus we find our long bond yields steadily falling, and the JSE All Share at 30500 signalling an imminent assault on the all time high achieved in mid-2008.

These strong leading indicators are fully underwritten by the experiences of the Minister of Finance. In his Medium-Term Budget last week, he reported an R31bn tax revenue overrun compared to last February's main budget expectations.

Besides better collection procedures, the real story is cyclical recovery in the economy and financial markets driving tax revenues higher without the support of tax rate changes.

Still, the country has incurred a massive increase in tax burden, only it wasn't advertised in those terms. For steep increases in electricity, transport, water and municipal charges are simply equivalent to tax hikes.

Despite these many stiff tariff increases, the Minister is unable to become more supportive as he needs his own tax revenues to return to health, allowing him to reduce his borrowing and slow the spiraling national debt. Still, the economy can probably stand these burdens, being strong enough to continue growing.

The ever lower interest rates provide welcome support.

Even credit growth keeps gradually turning higher, now 4.5% higher than a year ago, and household credit use over 6% higher (double the inflation rate). In contrast, companies have scaled back operations, improved their cash flows and continue reducing their dependency on banks, preferring funding from internal operations, indicative the recovery process is yet very young and has much farther to run.

The economy will also have to get by with a deep change in its credit culture, especially in the mortgage area. Lenders insist on realistic property valuations and most home buyers are required to provide own equity in their purchase, whereas previously banks were more than willing to overfund with future house price inflation in mind. For many households this probably means delayed home purchases, while existing homeowners may also find their calculations changed.

Still, the steadily dropping interest burden will ease existing mortgage payments, allowing easier degearing, or already freeing up space in household budgets for more spending, and especially smaller credit-linked purchases, with the mortgage market probably the last to so benefit.

Even if the sluggish job market so far has prevented a desirable broadening of the household consumption momentum, the strong income gains, recovery in bonuses and wealth effects and slow credit uptake all serve to underwrite a steady expansion.

Improving business confidence will provide important further support as 2011 unfolds, with last week also massive new credit guarantees forthcoming for Eskom, allowing it to gear its long-term infrastructure expansion with new confidence.

A pity the Financial Times (28/10/10) commented that in the eyes of many investors South Africa has become a country of rising labour costs, a corrosively strong Rand, a chronic electricity deficit, and a confusing political environment where property rights seem less secure in spite of official assurances to the contrary.

Mostly all own goals these.

Cees Bruggemans is Chief Economist of First National Bank.