This week Rand Merchant Bank (RMB) warned that the latest surge in oil prices, combined with higher regional maize price indicators relative to last year, would cause further price inflation.
While oil prices were expected to edge higher in the first quarter because of supply and demand dynamics, an economist at the investment bank is worried that the geopolitical risk between Russia and Ukraine has added to current price pressures as Brent crude trades around US$95/bbl (+53 percent y/y). Daniel Kavishe, who made this observation, still expects additional gains for the commodity, adding on to a number of concerns already raised by international experts.
Source: Bloomberg, RMB Markets
JPMorgan told CNN news that any disruption in Russia’s oil flows would “easily” push oil above $120 per barrel. Russia is the world’s second largest oil producer and President Vladimir Putin’s reported mobilisation to invade Ukraine comes at a time when the world is struggling to meet demand for oil.
Its prices rose significantly to sit at just above $90 per barrel. IMF has also cautioned that an escalation of tensions between Russia and Ukraine would almost certainly raise energy and commodity prices in many countries, keeping headline inflation rates elevated for a longer period, according to a news report by Reuters.
Oil prices implications for local pumps prices
If global oil prices continue on an upward trajectory, it is highly likely that they may influence local pump prices, although this often does not happen immediately. Generally, transport fares should track pump prices. Operation of personal transport inflation increases also since the actual prices of fuel consumers put in their cars for commuting will be higher, economists explain.
On the Consumer Price Index (CPI), transport has the largest weighting of 23.43 percent. There are fears that increases in fuel prices would hurt households, given that 70 percent of spending goes towards the necessities of housing and utilities, transport and food.
Brent crude versus SAFEX white maize prices
Source: Bloomberg, RMB Markets
Food inflation to remain upwardly sticky
Despite a bumper harvest in 2021 and the expectation for yet another strong harvest in 2022, Kavishe observes that regional maize prices are 10 percent higher than they were at the same time last year and this will cause food inflation to remain upwardly sticky for longer. Overall, supply-side pressures and their impact on consumer demand concern him. Inflation remains a key variable both internationally and locally, says Portfolio Manager at Kgori Capital Tshegofatso Tlhong. “Core inflation, a gauge of underlying long-term inflation, continues to trend above the headline inflation objective range of between 3 percent to 6 percent,” she notes.
Inflation prints 10.6 percent
This week, Statistics Botswana revealed that inflation kicked-off the year by printing a staggering 10.6 percent year/year in January (compared to 2.3 percent y/y in January 2021). Because of its weighing, the transport index was the main driver of domestic price growth, which contributed 6.2 percentage points to the headline number. This on the back of the last fuel increase effected on 20 December 2021, coupled with a P1.00 increase in public transportation fares for both taxis and minibuses. Other major contributors to the higher reading included utilities (1.4 percentage points), food and non-alcoholic beverages (1.0 percentage points), and miscellaneous goods and services (0.7 percentage points).
Source: Bloomberg, RMB Markets
Due to the timing of last year’s supply-side changes, with taxes, levies and tariffs being increased at the start of Q2 2021, inflation is expected to offer very limited reprieve over 1Q22, FNBB Quantitative Analyst Gomolemo Basele says. He concludes that upside pressure is expected from the transport index, with local fuel prices being adjusted to mimic higher international oil price changes in a bid to avoid under recoveries by oil importers. “Additionally, utilities and rental prices are expected to be upwardly revised due to reduced subventions from the government to major parastatals – to-date, the National Electricity Fund levy rate has been increased by P0.05 per KWh.”
Is inflation a positive negative for Choppies and Sefalana?
Tlhong argues that the uptick in inflation, though negative for low-income households, is positive for the consumer staples sectors. Being considered an essential service provider, Imara Capital’s Mogorosi Badisang and Kaone Ranko observed that the FMCG sector in Botswana was somewhat shielded from the negative effects of the COVID-19 pandemic in 2020 and 2021, albeit disruptions to cross border trading and temporary bans on the sale of alcohol and tobacco products. But whilst consumers have begun to visit stores more often than during the initial phase of the pandemic, Sefalana MD Chandra Chauhan says it is not yet at the levels they have seen in the past. “The consumer is still somewhat cautious and tends to focus more on necessities rather than luxuries,” Chauhan says.
Allan Gray MD Phatsimo Ncube explains that inflation results in the reduction of consumers’ disposable incomes, this reduction usually having a greater impact on discretionary spending. “This would be spending on items such as luxuries, entertainment and other non-essential items,” the fund manager writes to this publication noting that Sefalana and its competitors are more focused on food retail and other fast moving consumer goods. Accordingly, Ncube says these are non-discretionary and are among the last items to be trimmed from a budget when times are hard.
Adding to comments by Ncube, Tlhong expects the consumer staples margin expansion to continue despite inflation pressures on consumers. “Consumer staples are essentials. The basic food commodities. No matter how high the price goes, we need to eat (inelastic demand),” she explains.
In the six months ended 31 October 2021, Sefalana’s revenue was P3.5 billion, up 20 percent on prior period. Its competitor Choppies is currently finalising its financial results for the six months ended 31 December 2021 and expects profit after tax to grow by at least P104 million. While Badisang and Ranko expect corporate earnings in 2022 to somewhat normalise from the 2021 recovery inspired growth and, for the most part, gradually claw back to pre-pandemic levels, they also fear that with elevated inflation, sectors such as FMCG may experience margin compression with rising inputs and stiff competition forcing competitive pricing action. “Rising inflation may be cause for concern as stiff competition, predominantly in the company’s mainstay, Botswana, may push the company to price more competitively,” they argues, referring to Sefalana.
Ncube differs: “The effect of inflation, especially the seemingly transient type Botswana is experiencing, is unlikely to have a negative impact on Sefalana and its competitors in the short term as prices can be adjusted to pass on the inflation to customers.” Tlhong’s comfort is that in times of inflation, retailers can increase prices beyond costs increases (and costs have been escalating very fast these last two years), and more regularly so they can protect margins or even increase them, which is not the case in a low inflation environment.
Inflation impact on Sechaba
Badisang and Ranko caution about the impact of inflation on Sechaba Breweries. They fear that potential downside risks remain centred around the threat posed by new variants which may disrupt supply chains, thus driving up the price of brewing inputs and raising inflation, which may cause some consumers to opt for lower-cost alternatives such as wine which has potential to reduce beer sales for the company. Directly, higher fuel prices increase operational cost of businesses and they might tend to push such costs to consumers by increasing the cost for provision of goods and services. This will also increase inflation.
Inflation impact on property companies
Tlhong has also argued that inflation is positive for the property and expects inflation linked property rental escalations to be positive for the property sector. “Property annual rental increases are usually in line with inflation. So they can protect their real earnings. That is why property is an inflation hedge,” she says.
Ncube argues that the rise in inflation warrants an increase in rental rates for those tenants. The expectation is that tenants exposed to inflation linked rental escalations would sufficiently reserve funds in periods of low inflation in order to smooth out any impact from periods of rising inflation, Ncube adds. “The type of tenant also influences their ability to sustain this nature of the lease. Some tenants can pass on some of the inflationary pressures onto their underlying revenue providers (i.e. retailers to customers),” Ncube continues noting that these are some of the considerations made when property companies choose to offer CPI linked rental escalations. For other commercial properties, property experts argue it is actually the opposite: inflation is a negative. This is because typically the property owner would have tied the tenant into a relatively long lease of 3-5 years, with a fixed rental escalation that is not linked to inflation.
Say at the beginning of a five-year lease one has a 6 percent escalation clause and inflation was 2 percent per annum. Then one year into the lease, inflation spikes to 8 percent and stays there, it means that the property owner is receiving what is now worth less than it was at the beginning of the lease. Due to its five-year tenure, property the owner has no room to hike it beyond the 6 percent escalation. At the same time, the property owner’s costs are going up, likewise debt service expenses as banks adjust their interest rates in line with inflation. Similarly, from a valuation perspective, the discount rate must go up when interest rates increase, meaning property values must come down.
“From a property investor perspective, market valuations may come under pressure from capitalisation rates increasing in line with interest rate moves – which may rise due to inflationary pressure,” Ncube says noting that property companies listed on the Botswana Stock Exchange generally have manageable debt levels and adequate interest coverage ratios. “They have demonstrated resilience during the COVID-19 pandemic and have been able to collect most of their rental income.”
Nonetheless, observers would not say inflation is positive for listed properties, except that the asset class tends to maintain value as it is a physical asset. Having said that, two key metrics ought to be looked at. Property experts argue that there is a need to know the change in the discount rate that the valuer used, e.g. last one versus now with inflation up.
Secondly, they advise a look at what the WALE (weighted average lease expiry) of the portfolio is. Some of those who spoke to this publication say a low/ short WALE is good/better than a long/high one when there is inflation or inflationary expectations because it means a shorter period before one can increase rentals/escalations to take account of the now higher inflation. It is the opposite of a high/long WALE when there is low inflation. The above outline is premised on the assumption that the escalation(s) in the lease is a fixed percentage and not indexed to inflation.
While there are inflation-linked rental escalations, in a (previously) low inflation environment, experts argue that it would need a property owner who is very thorough and detail-orientated to have the presence of mind to include it in a lease agreement. Ncube supports: “Those that have CPI linked rental escalation rates have experienced lower levels of rental increase in the past 2/3 years as inflation was subdued” noting that “property companies have different lease terms and not all tenants have Consumer Price Index (CPI) linked rental escalations”. Since inflation has been low, most rentals are set at 8-10 percent escalation.