Why a 3% world rewards quality on the JSE - Merchant West

On 12 November last year, in the middle of a budget speech, South Africa changed the most important number in its economy. The Reserve Bank would no longer aim for inflation in a 3% to 6% band, the range in place since 2000. The target is now a firm 3%, give or take a point. It is the first change in 25 years, and it will shape what your savings are worth over the next decade more than any single rate decision.

By Bianca Lakha*

The thinking is sound. South Africa has long run inflation above its trading partners, which erodes the rand and makes lenders demand a fat premium. A lower, sharper target aims to break that habit, pulling down inflation expectations and, with them, the cost of borrowing.

For an investor, the significance lies in what a credible target does to risk. The premium built into our borrowing costs should fall as belief takes hold, lifting bonds and the shares priced against them. But belief is the catch: a target works only when people are convinced it will hold, and that conviction is built slowly, not declared. So, the real question is whether they are convinced yet.

There is a neat way to check. Picture two thermometers reading the same fever. One is a survey asking economists, business, and labour what inflation they expect. The other is the bond market, where investors back their view with real money; the price they pay reveals the inflation they are bracing for, the breakeven rate. When the market runs cooler than the survey, people are buying the disinflation story; when it runs hotter, they are betting against it. The gap between the two measures is the premium the target was set to erase.

For a while, both thermometers cooled together, with survey expectations at record lows and the market briefly even calmer than the forecasters. Then the war in Iran sent oil and fuel higher and the market’s nerves returned. Its reading jumped more than a percentage point in weeks while the survey drifted down. Part of the move is the market pricing a temporary fuel spike rather than lost faith in the target. But the premium has, for the moment, returned.

The split is less alarming than it sounds. The survey is backward-looking, so it shows where inflation has been; the market is forward-looking, so it shows where investors fear it is going. Their parting says the target’s credibility is still being argued over. The Bank's decision to tighten despite the oil shock is a deliberate signal of intent: hiking against forces beyond your control is how a central bank proves it means it. The market has not accepted the answer yet.

That hesitation explains a puzzle in the equity market. If a lower target is such good news for domestic shares, why have they not re-rated since November? Because the reward was always conditional on a belief the market has not yet granted. But the regime reshapes what wins in equities anyway. Inflation has long flattered weaker companies: when prices rise 5 or 6% a year, a business can show decent nominal earnings growth simply by repricing with the cost of living, whether or not it creates real value. At 3% that crutch is gone. Growth must come from something genuine, selling more or charging more because customers truly value the product, and firms with real pricing power separate from those merely riding inflation.

The subtler effect works through the discount rate. A credibly lower inflation rate should, in time, pull down the rate at which the market values future profits, favouring high-quality compounders, whose worth lies in cash flows years out, over cheap cyclicals priced for the present. Both effects push the same way: in a 3% world, if it holds, the businesses that pull ahead are the genuine compounders, with durable pricing power and high returns on capital. Inflation will no longer do their work for them, which is why this regime, once trusted, rewards quality over the merely cheap.

None of this is settled. The target is less than a year old, as Governor Kganyago concedes, and a prolonged energy shock could challenge the Bank’s resolve. It also has critics who worry it favours price stability over growth and jobs. This is a regime change in progress, not a victory lap.

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At Merchant West, we weigh a signal like this against many others, the bond market, the rand, the prices companies can actually charge. On balance, we think the lower target is a genuine improvement and the early progress real. But credibility of this sort is won slowly and can be lost quickly, and the recent wobble shows it has not yet been earned. The 3% target has not failed its first test. It is still sitting it.

*Bianca Lakha, Equity Analyst - Merchant West Investments

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