Closing the gap – How SA benefits from lower US inflation

Last week South Africans benefitted from a powerful demonstration of our integration into global capital markets. On Tuesday, the yield-to-maturity on the key 10-year US Treasury fell from 4.63% to 4.44%. By the end of the day, the 10-year RSA bond yield had declined by a similar number of basis points, from 11.66% to 11.45%. The yield on a dollar-denominated, five-year RSA bond fell from 7.52% to 7.19%, leaving the yield spread with the US Treasury, an objective measure of SA sovereign risk, slightly compressed at 2.76%. The US dollar weakened across the board. And with higher bond values the share markets almost everywhere responded agreeably for investors and pension plans. The JSE gained nearly 2% on the Tuesday (5% in US dollars) and again by a further near 2% on the Wednesday.

All of this on the news that inflation in the US had fallen by a little more than had been expected. The chances of further increases in short-term interest rates therefore fell away, as they have in South Africa. And long rates moved in sympathy. Should the US economy slow down sharply, as slowing retail spending suggested they would in a print released on Thursday, declines in US short rates will follow in short order, adding to US dollar weakness and rand strength. Or at least as investors, if not yet the Fed, thinks.

US Inflation: annual, quarterly and monthly

Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment, 16 November 2023

Some may say this is much ado about relatively little – a mere blip in the inflation data. If you could predict nominal US GDP and interest rates over the next 10 years, you would be able to predict share and bond values with a high degree of accuracy.

Perhaps the most intriguing feature of recent trends in US GDP has been the growing share of corporate profits after taxes in GDP. The ratio of these profits to GDP has nearly doubled since the early 1990s. A profit ratio that investors must hope managers, with the aid of R&D, in which they invest so heavily, can defend to add to share values.

Another question about the long-run value of US corporations and their rivals elsewhere will be about the cost of capital by which their expected profits will be discounted. A puzzle that has arisen is: why have long-term interest rates in the US increased as much as they have this year? It is not inflation expectations that have driven up yields. They have remained well-contained despite higher rates of inflation. Quantitative tightening – the sale by the Fed and other central banks of vast amounts of government bonds bought after the Global Financial Crisis and during Covid-19, is surely part of the explanation.

But it is not only vanilla bond yields that have risen this year. Real yields (inflation protected) have risen dramatically this year, from near zero earlier in 2023 to their current over 2%. Capital has become not only more productive of profits in the US, but it has also become more expensive in a real sense, to counter productivity and profit gains when valuing companies. Will it remain so? That is the trillion-dollar question.

US share of after-tax corporate profits in GDP

Source: Federal Reserve Bank of St Louis, Investec Wealth & Investment, 16 November 2023

The gap between real interest rates in SA, where a low-risk 10-year inflation linker offers over 4% – making for very expensive capital for SA corporations – has narrowed sharply. Surprisingly perhaps, real interest rates in SA have not followed global trends, making for at least relatively lower costs of capital for SA-based corporations. This is good news, which we can hope will lead to more investment.  

10-year inflation-protected real bond yields in SA and the US

Source: Bloomberg and Investec Wealth & Investment, 16 November 2023

Risk spreads – RSA minus US 10-year bond yields

Source: Bloomberg and Investec Wealth & Investment, 16 November 2023

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