Episode Transcript
The Finance Ghost: Welcome to episode 276 of Magic Markets. And if you are listening to this in your car right now, which I know that many of you will be doing, it's quite unfortunate that it is costing so much more money to actually run that vehicle that you are currently in. And that is part of what we're going to talk about this week because obviously petrol prices have gone bananas.
But we are going to link that to what's going on with inflation, the fact that we've now seen a rate hike from the SARB to the disdain of many.
Moe, welcome to the show as always, and let me just bring you straight in here. Is this a situation where every problem looks like a nail when all you have is a hammer at the SARB?
I know you certainly know the people involved there and everything else. So maybe you can give us a better understanding here of why they go and do things like raise rates into a struggling consumer base when inflation is being caused by something completely out of our control, being the petrol price
Mohammed Nalla: Ghost, always a pleasure to do this with you. We're doing a show which will probably be released around a week after the SARB hiked interest rates. I think it's nice to just take that time, digest, and see what's really going on.
To your point around a nail and a hammer, I think it's a fair criticism on the surface because clearly the SARB can't solve the root cause of the problem of higher inflation as we're seeing right now.
We've had inflation, just within the span of a month, move from like 3% to 4%. That's directly as a result of what's happening in oil prices.
Now, how do interest rates in South Africa actually affect oil prices? Well, they don't, in short. But I think that's the mistake that the market's making out there. A lot of the criticism out there around the SARB is centred on the fact that, oh, it's exogenous, you can't do anything. That doesn't mean that they shouldn't do anything because, if you actually look at that, it's not what the SARB's targeting. They know they can't solve an oil crisis globally.
What they're looking to do is they are trying to prevent the second-round effects, because that is something that they can actually do. So it's not really a hammer in search of a nail. It's the fact that the SARB understands the nuance around how prices are then transmitted, or price increases are transmitted, through the system.
So, for example, your first round is inflation, the petrol story, right? But the second round is when businesses raise their prices more broadly to incorporate some of that cost, and then that goes through into workers' wage demands. Consumer expectations then become unanchored, and all of that becomes a self-reinforcing negative spiral.
I think that's the part that monetary policy is looking to influence.
For context, they've raised it by 25 basis points to 7% on the repo. I think it's just over 10% on the prime lending rate, and it wasn't a unanimous decision. So I think that's also quite important because it shows you that they are having the debate at the MPC level. You had a split vote. It was four in favour of the hike or two saying no, we want to keep rates where they are.
But it is also their first hike since, I think, it was 2023. So this isn't a move that I think the SARB took lightly, but it's one that they really had to balance. They had to argue amongst themselves, and I think the uncomfortable message here is that the SARB is actually, very correctly so, choosing to lean against inflation credibility. It's a credibility story. They've got to be seen to be a credible central bank, certainly as a small open emerging market.
And that has to come despite the fact that consumers are under pressure because the situation, if this continues, looks very much like a stagflationary risk, with low growth and inflation that is actually stickier and trending higher.
The Finance Ghost: It sounds like what you're saying is they can't do anything about the oil price, obviously - we know that, and petrol and everything else. There is an effect on the currency. If they go and try and target inflation, that actually helps the rand, and we can talk about that just now, which kind of helps with the petrol price as well, to be fair.
These second-order effects, basically we're just saying, you know what, it is what it is. The SARB has this tool at their disposal, and it means that South African consumers will be spending more on essentially their debt, firstly, and secondly their energy costs, because there's nothing that we can do about it.
You almost squash demand in other things to try and bring inflation under control. And that's what makes it so ugly, right, from an economic perspective, is it is essentially just reining in demand and reining in spending. But in a country where GDP already sucks, and that's the problem.
Mohammed Nalla: It's that to a degree. If you look at South Africa, what's very interesting is that it's such a diverse market where a large portion of the population won't be directly impacted by the hike in interest rates. If you look at the percentage of the South African population that have mortgages, for example, that's a lot smaller than the rank-and-file South African who actually gets hit by inflation a lot worse.
If you look at the social construct of South Africa, the SARB's got to be cognisant of that as well. They've really got to hone in on inflation. It's a different story if you're sitting in a developed market like the US, for example, like Canada, where your mortgage exposures are quite large.
And again, we'll talk about the yield curve shortly because there's the long end of the yield curve, which is where mortgages get pinned at here in North America. But in South Africa, it tends to be related to the short end of the curve.
What I want to actually touch on is that it is a bit about crushing the demand in other segments of the economy, just to ensure that overall inflation doesn't get baked in. But I don't think that's the primary impetus. The SARB is really focused on that second-round effect that I mentioned. They're not going to allow what is supposedly a temporary oil shock to become permanently embedded inflation. And that happens through that expectations loop that I mentioned.
That's really the core message that a lot of South Africans maybe struggle to understand, because it's taking the tough medicine when you need to. If the SARB didn't do this and inflation expectations become unanchored, remember the target's been moved lower as well, and that's a whole separate discussion for another show, but once that happens, if it filters through into wage negotiations and prices in general, second-round effects, that is very difficult to then dislodge and reverse.
And they've done a lot of work over the last several years to ensure that that remains anchored. I think that's the primary reason why the SARB has to actually move, despite the supposed distress that will obviously come through in the shorter term.
The Finance Ghost: Yeah, look, the truth of it is that - it's just the reality in South Africa, as you say, mortgages and everything else, it does suck, and the middle class is under a lot of pressure, let's not pretend they aren't.
But for people who are spending half their money on transport just to get to work and back, the fuel price hike is the difference between having food and not, or having electricity and not. So it's just a really tough scenario brought on by what's going on in Iran.
Perhaps the trick was to just not go and have a fight in Iran! That might have done wonders for inflation. But second to that, the SARB's not in control of that, and all they can really do is try and just tick it up.
It went up by 25 basis points, which, on our structurally high interest rate as a percentage, is actually not that much. When you see moves like that in developed markets who have lower rates, it's actually a much bigger deal, right?
Mohammed Nalla: Yes, but I also wouldn't get too comfortable around the 25 basis points. If this persists for a while, you may actually see another 25 basis points at the next meeting. I think the SARB's going to really just make sure that those anchors remain in place.
You've touched on an interesting point. You mentioned the rand, you mentioned the international oil price and what's happening there. Let's maybe go to the rand and then over to bond yields because I think they're kind of related. They tend to move together sometimes.
But if you look at the rand, I think the rand strengthened post the news of this rate hike. And why would it do that? Because it was in the context of a flat dollar move internationally. So you could argue that is directly related to a domestic factor, being the interest rate move.
What's actually happening there is because the SARB is out there anchoring long-term inflation expectations, that credibility really matters, because what happened on the yield curve at the same time is you actually saw the long end of the yield curve move lower. So if you look at the 10-year yield, if you look at the 30-year yield, those moved lower in response to the SARB hike in the short end, even though the short end moved higher. So, a flatter yield curve overall.
Now this, again, is actually quite interesting because that talks to a longer-term structural benefit of SARB credibility, because companies invest based on where their long-term funding is. Maybe in the short term, consumers on their credit cards are going to get hit hard, but the overall investment narrative in South Africa actually improved following the SARB's decision.
And that talks towards what I would call a credibility dividend. That's really telling you, yes, we know inflation in the shorter term is a risk, but the long-term credibility is so important that it's anchored inflation expectations. We don't think this is going to run away.
Tying that back into the rand, South Africa is very exposed to that imported inflation. But because of that reaction on the bond market, and then the rand actually strengthening, if you compare it to other emerging markets as well as majors last week, the rand strengthened in aggregate. So I think it is related to local idiosyncratic movements there. By hiking, the SARB is defending that currency channel, and that filters through into mitigating the impact of inflation from imported and exogenous factors.
So yes, I would say the rate hike is definitely painful. It doesn't optically feel nice for consumers, but the longer-term dividend in terms of credibility is really so important.
I want to come back to the hammer and nail analogy because, yeah, interest rates are a blunt tool. It's unfortunately what policymakers have to work with, and they can't solve that supply shock directly. But I don't see this as the SARB using this hammer to try and fix the oil supply problem.
The core message here is a small open economy like South Africa has to control inflation, control the optics, and through capital markets like the bonds, like the rand, the SARB actually is achieving what they set out to do. So I am in support of the decision, despite how hard it is.
We discussed a lot on this macro side. I want to kind of bring this back into a nuts-and-bolts discussion on the JSE. We actually see the results of these interest rate moves. It has a different impact on different sectors, but there are also a few turnaround stories on the JSE right now, including in the retail sector.
So what's really the driver here? The impact of the rate hike, is that actually a bigger impact than some of the turnaround stories we're seeing on the JSE? What's actually happening in South African financial markets beyond the currency and beyond the bonds?
The Finance Ghost: The retail sector is extra interesting at the moment because there really is this huge deviation between the winners and the losers. I think more than I can remember seeing in ages, actually. So there's just nowhere to hide anymore. You've got a scenario where this big shift into on-demand and omnichannel retail has really separated the weak from the strong, and then the weak are just getting much worse, especially in grocery.
It's extremely difficult to turn around a grocery business, so Pick n Pay is hugely struggling at the moment. SPAR released a truly diabolical update last week, one of the worst I think I've ever seen. Horrible, horrible, horrible. It's not looking good there.
There's a bigger story here, obviously, which is how these interest rate hikes actually hit all of these equities, but specifically these companies that are looking a little bit weak at the moment. So the first thing we need to accept is that this is actually a bit of a two-layered issue.
First point is any company that runs on debt ends up being exposed here. We need to then understand what that actually means.
So let's deal first with companies that run structurally indebted balance sheets. Property funds would be a really good example here. They run at a lot of debt. They have loan-to-value ratios that sit somewhere between 30% and 40%, unless they're in a lot of trouble, when sometimes it's higher. And so obviously when rates go up, they just pay more of their income to the bank. It's as simple as that. That's the maths. You're taking a pie, you're cutting it into pieces for the bank and pieces for equity investors, and the piece for the bank is now bigger.
Now there's sometimes a double whammy there, depending on what happens with bond yields. Because if bond yields are also going up at the same time, or roughly the same time - not necessarily exactly in response to an interest rate hike, but just generally - which is what you would often see when you've got inflation worries, then you have a scenario where the asset value is also under pressure. So asset value under pressure in these property funds, plus a bigger proportion of income goes to the banks.
So property funds don't really like it when interest rates are going up. Although if they've locked in good lease escalations, they've got protection. If they didn't lock in great lease escalations, then they have a bad time. So that's property.
Then you've got operating companies that have taken on debt that isn't necessarily a structural part of their business. It's because they've got major capex, for example, or big acquisitions. Sometimes they just take on too much, and then the cycle washes away from them.
So a really good example at the moment would be Sappi. Gemfields was another recent one that ended in them having to do an equity raise. Will Sappi end in a similar way? I don't know. We'll have to wait and see what happens. But it can lead to a big disaster. If companies go and over-indebt themselves at the wrong point in the cycle, that can get ugly pretty quickly.
The third type of company that is also worth touching on is companies that use debt during a period or throughout a period, but it's not always clear at the period end. So, for example, working capital can be funded with short-term debt, but if they pay down that debt right before the balance sheet date, then when they actually report, it looks like they have much less debt than they have been running at throughout the period.
And you pick that up by having a look at their net interest cost, their net funding line. So this can sneak up on you because your typical debt screening ratios may not pick this up. It might look like there's not a lot of debt in the system when actually they use it all the time.
So the first thing to think about when interest rates are going up is the extent to which you are actually exposed to highly leveraged stocks in your portfolio. That's the one thing.
Then we have the second point, which is the impact on customers of rising rates. And that's the point that you've made, Moe. That's the second-order inflation effect. That's the steps that the SARB or other central banks have to take in order to actually rein in inflation.
It might be easier to predict in some sectors like retail, but even then there's a big debate around discretionary versus defensive retailers. Because even defensive retailers make their best margins from the discretionary categories. They don't make their money from the defensive stuff, they make it from the other stuff you put in your trolley, or add to your cart on your phone these days.
So how defensive are they really? Well, that often depends on valuation. Because if the market is paying a massive valuation for these stocks, if that margin washes away because the discretionary categories come under pressure, then that valuation can very quickly disappear.
A good local example: go and look at how Clicks has significantly derated in recent times. Dis-Chem is hanging on for dear life, but under pressure. Those valuation multiples have deviated considerably, and that is something to keep an eye on.
Where do we find a retailer in a turnaround in a Venn diagram of pain, right? These are retailers exposed to customers who are now paying more to the bank and hence have less disposable income. Plus that retailer itself probably has debt and probably needs to sell non-core assets, if they have any left, to try and reduce the debt, and even need to go to the market to actually go and raise equity funding to try and save the story.
That's why turnarounds are a tough place to be in this environment, and especially retail turnarounds. In my opinion and certainly in my own portfolio, it’s not the best time to be rolling the dice on difficult stories right now.
The other trade might be to just follow the money right to the other side. It's banks. The banks are receiving more, than follow the money there because within a range of reasonable rates, an increase in rates is actually good for the banks.
Mohammed Nalla: That banks point is so important because it is quite nuanced. They do benefit from the higher rates at the margin, that's for as long as the credit quality doesn't deteriorate too materially.
And in fact, in Magic Markets Premium this week we're covering MercadoLibre, a company exposed to Latam. Very much a fintech play there, and the moves they've been making, certainly in terms of their credit book, look incredibly like a bank. So if you're interested in what's happening underneath the hood there, just go and have a look at that if you're a subscriber. If not, it's only R99 a month. Great value.
I just want to circle all the way back to our upfront framing because this is not about the SARB trying to solve an oil shock, which is where a lot of the criticism comes from. It's really around those second-round effects. I want to hammer that point home. I think that's the hammer we should be looking at, is hammering home the fact that the SARB is interested in the long-run effects here and making sure that inflation expectations do not become unanchored.
And I think if you look at the market reaction in the shorter term, it's telling you that that policy signal actually worked, at least initially, right? Over the longer term, we'll need to see how that plays out.
But the growth risks in South Africa are not really related to the cost of funding. It's not really related to interest rates, it's related to other structural factors. Yes, the consumer pain is real. I'm not going to actually pooh-pooh that. I think that's important.
But the pressure on South African companies will come through if inflation becomes dislodged. That becomes a lot more acute. And it's not just the companies, it's also the consumer on the ground. Maybe has a mortgage, maybe doesn't have a mortgage, but inflation bites and hurts a lot more.
The simplest way to say this is that yes, the SARB can't fix oil, but it can defend its credibility. And I think it's done a really good job of that, because in South Africa, credibility is not a nice-to-have. It's the anchor behind the currency, it's the anchor behind the bond markets. And so that is effectively the cost of capital across the entire economy that the SARB is really standing as the bastion, trying to defend.
For me, I'm not a shill for the SARB, and I think it was the responsible move. I want to see whether we actually see another hike at the next meeting. I think the risks are there because the SARB's own forecast for inflation have actually escalated, and that's related to just the global situation.
If that eases, I think you would probably see the SARB willing to reverse that direction as quickly as they've actually passed the rates through. I think they deliberated on this quite strongly.
Unfortunately, that's where we're going to leave the discussion this week. Let us know what you thought. Hit us up on social media. It's @MagicMarkets, @FinanceGhost and Mohammed Nalla, all on X, or you can find us on LinkedIn. Pop us a note on there.
We hope you've enjoyed this. Until next week, same time, same place. Thanks and cheers.
The Finance Ghost: Ciao.
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