raymondparson

Michael Avery

Time for The Week That Was with Warwick Lucas, Private Clients Portfolio Manager at Vunani, and Professor Raymond Parsons from the North-West University Business School and the University of the Western Cape.

What a week! We talk about it every week, but the bond market has spent another week reminding everyone ‘who actually runs the place’. US yields are well above 5%. Oil remains above $100. Central banks are hiking again. And our own SARB has just poured a bit of petrol onto that fire, while also trimming growth to 1.2%. So money costs more, energy costs more, growth is weaker. Welcome to Friday.

Warwick – let me start with the number that really changes the investment conversation: that US 10-year yield above 5%. We spent much of the last few weeks talking about oil and inflation, but this feels a lot broader now. If yields are rising because the economy is strong, it’s one thing. If they’re rising because investors want greater compensation for inflation uncertainty – and all these enormous fiscal deficits and relentless Treasury issuance from US Treasury Secretary Scott Bessent – it’s quite another situation.

Are we moving from monetary policy risk into ‘fiscal risk pricing’?

Warwick Lucas

Hi, Michael. Yes, that shift is happening. The 5% 10-year yield in the US is a global discount rate that basically is saying, “I need more compensation.” So, monetary policy risk is where we ask, “What’s the Fed going to do at the next meeting? Fiscal risk pricing is: what yield do I require to lend to a government that’s issuing vast amounts of debt while inflation remains uncertain? And that, suddenly, gets a much bigger conversation. Because, yes, the Fed can influence short rates, but they can’t influence the long rates.

Michael Avery

Yes, exactly. And as an investor, what do you want to know? How much inflation is expected? How much is the expected path of short interest rates? And how much is real yield? And what part of it is just simply: if you want me to lend Washington money for 10 years now, you’re going to have to pay me more because we don’t trust the story anymore? And that will hold up the world reserve currency and the fact that we recently crossed 40 trillion US dollars in debt.

Warwick Lucas

Yes, absolutely. A 5.2% 10-year yield isn’t just one thing – it’s a whole bundle of risks. I mean, part of it’s expected inflation. And if investors think inflation will settle above the Fed’s 2% inflation target, they want to be compensated. Part of it is the expected path of the short rates. And the Fed’s just hiked.

So the market thinks more hikes are possible. So, the 10-year has got to reflect that. Part of it is also real yield, which is the return after inflation. But the most interesting bit, of course, is the so-called ‘term premium’. That’s what one could describe as a ‘country risk premium’. But I tend to call it the price of being an idiot. And it’s whether you put out policies that drive everyone else mad! And in the case of South Africa, it was the difference between being inside the GNU and outside it. And that, we saw, was about 1.5% to 2%.

You want to have confidence in who you’re lending to. And frankly, the US Republican government as it stands is not someone that you could have confidence in. We pointed out that a massive rollover of US debt would come this year. There’s a huge mountain of it. You had to have a laser-like focus on what you were doing when you were rolling that over.

And they didn’t. The policy was anywhere but dealing with this particular problem. So now we’ve seen the result. You’re just paying more and more and more. And I think it’s not often that you have markets looking towards the US mid-term elections and saying to themselves: Do we really want the Conservatives to win?’

Michael Avery

Well, it doesn’t look like they will if you look at some of the forecasts. So it’ll be interesting to see what happens if that plays out the way the betting markets, forecasters, and pollsters expect, with the Democrats coming roaring back.

But Raymond – this is also where the story becomes bigger than just markets, because central banks can influence the overnight price of money. To Warwick’s point, at the short end, they don’t control the long end of the yield curve. And the Fed raised rates by 25 basis points last week. It did it unanimously. The language is strikingly simple: “The Committee will deliver price stability.”

Would you say something has changed in the global monetary policy regime now that central banks spent several years worrying about doing too much? Are they now much more frightened of allowing another inflation shock to become embedded?

Raymond Parsons

Hi Michael. I think it is indeed a much bigger story now, and it also changes the whole policy conversation for South Africa and several other economies. Because we’re seeing a synchronized shift by several key central banks reflecting their concerns about global inflation anxiety and renewed inflation fears. And it’s driven, of course, as we know, by a persistent combination of factors.

We’ve got the continued energy shocks, the trade tariffs, debt issues and the significant AI investment boom. So key central banks are now pivoting toward tightening and wanting to anchor inflationary expectations. On the other hand, some central banks have decided to stay put for now and not take any pre-emptive action because of the uncertain outlook. So, what eventually matters is that monetary policy responses are ultimately not a purely technical exercise, but a judgment call depending on data and the central bank’s remit. And that judgment call can differ from one central bank to another.

Why? Because it’s a question of timing and also in responding to domestic economic circumstances. It’s the domestic economic circumstances that decide how much room you’ve got internally and what you need to do with that space that you’ve got in relation to global shocks. So, when you talk about monetary policy from a global point of view, you cannot just argue that ‘one size fits all’.

But looking more specifically at the immediate US outlook in the light of the latest market trends, I suspect what we’re seeing now is that, whereas before there was a pencilling in of only one more rate increase by the Fed by the end of the year, it’s now quite possible you might get two interest rate increases there before the end of the 2026.

Michael Avery

Yes, that’s where the markets are beginning to point. Warwick, let’s bring equities into this, because markets do seem to be trying to hold two seemingly contradictory ideas at once. We’ve got this huge AI enthusiasm that continues to keep parts of the equity market remarkably buoyant, while the supposedly risk-free discount rate underneath those valuations has moved above 5%.

So, at what point does that maths become too uncomfortable to bear? Because if I’m an investor, I can earn north of 5% in US Treasuries. What happens to the ‘hurdle rate’ for investing in everything else?

Warwick Lucas

The question you ask yourself is: has the equity risk premium changed? Because are your US Treasuries suggesting, because of risk pertinent to Treasuries, or is there a higher riskiness inherently in your AI space now? The maths is certainly uncomfortable, It’s just not bitten because AI fever is so strong.

Certainly, a 5% Treasury yield is obviously a hell of a number – it can certainly attract a lot of capital. It forces equities to sweat harder, property to deliver higher yields, private credit to offer more compensation, etc. So these AI companies, though, are currently showing the kind of growth that can easily overcome a higher discount rate on its face.

The question is the difference literally between, say, an expected higher growth of 80% revenue and 100% revenue. You never quite know which one is going ‘to throw the switch’ and suddenly not be good enough. What it does mean is that there’s a big, compact risk growing in AI. But it’s incredibly difficult to put a number to that.,And that’s the point. And the point is the pricing for perfection.

Unfortunately, you can’t just say, well, that’s the same as being expensive because it’s not – kind of ‘an unknown unknown’. And that’s when risk management becomes an important part of managing a portfolio.

Michael Avery

And investors don’t fully understand the scale of what’s happening here. I was reading The Wall Street Journal this morning that the AI build-out is on track to become the single biggest economic bet in US history. Not the internet, not highways, not the railroad boom, none of that. The Wall Street Journal estimates that US data centre and AI infrastructure investment could reach 10.3 trillion US dollars between this year and 2032, It works to roughly 3.6% of GDP per year. It is enormous. And AI ‘is becoming the economy’.

But I want to bring it closer to home. And Lesetja Kganyago, the Reserve Bank governor, Raymond, spent quite a lot of time discussing precisely these kinds of transmission mechanisms. The SARB says it watches the G3 central banks, not because it follows them basis point for basis point, but because higher developed-market yields tighten global financial conditions. They affect emerging-market capital flows, which is right.

But it sounds like the uncomfortable reality for a small open economy: that we may set our own repo, but we don’t set the global price of capital. So, how much room for manoeuvre does South Africa really have when US long yields are above 5%?

Raymond Parsons

Well, Michael, this is the classic macroeconomic paradox for South Africa, as it is for several other emerging economies. So I’d like to make the following points regarding the decision by the Reserve Bank yesterday.

But let me say immediately – it’s not a criticism of their decision. Rather, it’s a critique of what options were available. We must acknowledge that, given the Bank’s mandate around its 3% inflation target and the credibility issue, I expected a rate increase would be inevitable. But a plausible case could also have been made for another pause in rates, coupled with a hawkish message.

To begin with, the data on inflation expectations was treated ambivalently. In fact, the MPC ignored what was favourable in the recent BER survey and injected something as to how the MPC itself now saw the outlook for inflation expectations. Core inflation had also declined in August. Secondly, whatever the motivation for yet higher rates, it will not alter the consequences that follow for economic activity and growth. The MPC has progressively reduced its growth forecasts for 2026 in recent months from 1,6%, to 1.4%, and now to 1,2%.

Finally, research has shown that about half of the rand’s movements and interest rate differentials are driven by external factors – but the other half is from domestic factors.

We need to be seen to be doing more to mobilise the positive second half of the equation, over which we have control.

Michael Avery

Yes. I guess one of the critiques of the decision is – and Warwick, to bounce this one over to you – is really at what point does fighting inflation, being worried about those ‘second-round effects’, become important. I’m not surprised the SARB is worried about them, given what we’re seeing with the rise in diesel costs, and will that spill over into wage demands – I would not be surprised to see that happening – still it doesn’t come at zero cost. So at what point does fighting that kind of inflation begin to do more damage to growth than the inflation itself?

Warwick Lucas

That’s always a tricky one. And it’s often the dilemma. By the way, you often have to ask yourself, as Raymond pointed out last week, the old dilemma that Alan Greenspan had: ‘if I do nothing, what’s the cost? And if I do something, what is the cost?’ And it is certainly a very tricky situation here. One thing we have to be very wary of is exposing the country to a currency crisis. We can’t allow a massive dislocation between South African interest rates and US interest rates just yet.

In the fullness of time, as respectability is restored, we could take a more divergent path, but perhaps not at this stage, especially since these fuel price hikes that are coming through are going to be a bit ugly. And whether or not it’s ‘cost-push’ and one agonises over it, ‘inflation is inflation’. It’s going to come through. So, I see the Reserve Bank’s hand is very much forced at this stage, Michael. And in fact, they were quite gentle.

Michael Avery

Yes they did say they discussed a 50bps hike and they also discussed doing nothing. So, it’ll be interesting to see how we go from here.

There’s another interesting counterpoint in Lesetja Kganyago’s argument, Raymond, because he pointed out that South African bond yields have risen, but nowhere near as dramatically as US yields, and certainly not to the levels we’ve seen elsewhere in the developed world.

Let’s interrogate that, because it might be one of the more important economic developments we’re not talking enough about. Because for years we worry that just the slightest global risk-off event -someone sneezes and we get extremely drug-resistant TB. We’re punished, the rand would be punished, bonds would be sold off.

Are we saying now that through more credible, obviously, monetary policy, but also fiscal policy. There’s that lower inflation target and we’re expecting a fourth year of a budget primary surplus – that we’ve bought the economy ‘some breathing room’, in practical terms, to be able to navigate, negotiate this period slightly better than we would have, say, five years ago?

Raymond Parsons

I would have thought so. The reality test here, when we weigh up the external and the internal factors we have to deal with, comes back to the fundamental dilemma we still keep wanting to dodge. To get people to lend to you, you must be seen to be financially resilient and credible, and do all the conventional policy things that we have all supported. But if you want people to invest in the country and help to reduce unemployment, you need to show economic growth.

We are not yet showing that balance sufficiently in the policy mix. We are indeed saying, yes, we’re doing all the right things for people to have confidence to lend to us, but we are not doing enough of the right things, both short and long term, to create an environment with growth prospects on a scale that makes South Africa a highly preferred investment location for substantial fixed investment commitments. So, we are facing this dilemma which we haven’t successfully navigated yet.

In the meantime, the SARB has confirmed that, when we face our Medium-Term Budget next month, we’re now at a 1.2% growth rate projection in 2026 and still within a narrow 1%-2% growth corridor. So, we need to see who are the winners and the losers here, and what are we doing to encourage the fixed investment, not just the lending, that the country needs now? And getting that balance right is tremendously important for a country like South Africa.

Michael Avery

Raymond Parsons, thank you very much, along with Warwick Lucas. As always, great insights.