Financial markets are currently in the midst of adjusting to a world of rising interest rates. With the threat of deflation having subsided and the world economy growing at its fastest pace since 1999 US interest rates are set to rise substantially. Such a rise in the world financial markets benchmark interest rate will influence investor behaviour and capital flows significantly. All asset classes, currencies and markets that benefited from years of falling and negative real US rates will find their fortunes changing and vice versa.

South African markets will not escape these adjustments. In recent years low international interest rates boosted demand, including the demand for commodities, and commodity prices experienced their biggest boom in five to ten years. Rising international interest rates will probably reverse this trend in future.

Furthermore, rising international interest rates will improve the attractiveness of the major markets fixed income investments. Whereas negative real US interest rates benefited high yielding emerging market currencies, a normalization of US real rates will probably suck capital away from the high yielding currencies. Typical capital flowed away from emerging markets during periods of raising US interest rates, this time round will probably be no different.

As a high yielding, commodity exporting currency the rand was a major beneficiary of low and negative real US interest rates. These sources of support are expected to wane over the next year or two.

The huge appreciation of the rand the past two years has impacted significantly on the local economy. Inflation has dwindled close to zero, interest rates have fallen to their lowest levels in about twenty years and the real purchasing power of households has soared (particularly on international goods and services). Furthermore, the biggest residential property boom in almost thirty years has boosted household balance sheets and household appetite for credit is growing at about 20%. The latest FNB/BER consumer sentiment survey confirmed the favourable circumstances for households, with consumer sentiment zooming up to historically high levels.

Spending in the local economy is further boosted by government spending accelerating (with the arms procurement programme in full swing) and business stepping up investment outlays. In addition SAA is replacing its fleet.

 Real final domestic spending growth reached an historic high of 5.4% in the first quarter of the year and looks to have accelerated in the second quarter.

Unfortunately little of this historic spending boom (locally and internationally) is feeding through to local production. Import volumes are ratcheting up at a rate of about 15%, whilst export volumes appear to be flat. Industrial production growth recovered, but is still lagging local demand significantly. Clearly local producers are losing market share in the domestic as well as international markets. All these trends suggest the rand is not currently priced correctly. Recent evidence of a sharply deteriorating trade balance and rapidly growing current account deficit support this view.

The South African rand remains one of the most actively traded emerging market currencies in the world. In the second half of 2001 the rand lost more than 40% of its value and since gained back substantially more than its losses. This volatility created a tough environment for business and investment professionals and South African competitiveness in general. Other emerging market countries like Thailand and Korea were also exposed to similar global forces, such as a weaker dollar and improved emerging market sentiment. However, unlike the SARB, their central banks decided to intervene by building foreign reserves in an attempt to cap the appreciation of t heir currencies and remain competitive in global markets. By following this policy their currency volatility remained below 5% while rand volatility increased to over 20%.

A rand model driven by the inflation and interest rate differentials between South Africa and the USA, the OECD leading indicator and the Economist commodity price index, suggests the rand is more than 20% overvalued.

Currently the outlook for interest rates is highly uncertain. If the rand manages to maintain current levels one could well envisage scope to reduce interest rates. The strong rand is disciplining inflation and CPIX should remain comfortably in its target range.

However, with international interest rates rising and potential pressure on the rand, this scenario could easily be turned on its head. With consumption booming, any turnaround in the capital inflows currently supporting the rand and domestic consumption, interest rates will have to increase.

To predict interest rates with any degree of confidence in such a fluid scenario appears to be a very hazardous exercise.

ISSUED BY: CITADEL

For further information please contact:

Dave Mohr
Chief Investment Officer
Tel: (021) 940 7200

OR

Maarten Ackerman
Investment Strategist
Tel: (021) 940 7200