Global outlook and the SA economy – the good, the bad and the ugly

By on July 24, 2013
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During Q2 2013, the murmurings of US policymakers sent tidal waves of uncertainty across the global and local economic landscapes. In our view, the potential for Fed tapering was blown out of proportion, offers Johann Els, senior economist, Old Mutual Investment Group.

The reaction of investors was to the degree that many people believe that it has set in motion the wheel of the Great Rotation…. coined to name the move away from bonds into equities; and the decreasing attractiveness of emerging markets relative to developed markets – specifically the USA (and to a slightly lesser extent Japan). This has also highlighted to foreign investors the specific problems in South Africa and, as a result, we have seen the weakness in the rand.

In the west: why there is talk of tapering and what does it mean?
There are significant structural improvements in the USA’s economy, including: healthier household balance sheets as household debt as percentage of household disposable income has reduced from 135% at the end of 2007 to 110%;  significant improvements in the two sectors most severely impacted by the crisis, with vehicle sales now up 50% and new home sales up close to 80% from the slump; corporates are healthy (profits as a percentage of GDP are at an all-time high); and, last but not least, the US’ anticipated energy independence as increased oil exploration and a robust fracking industry promise to put an end to their oil import dependency around two years.

These improvements promise to build on the cyclical recovery in the USA and should result in stronger growth in coming years. And, while the current recovery is still below trend, when combined with low inflation, this gradual recovery supports the continuation of policy stimulus, and Fed officials have moved to calm the markets by reiterating that tapering of quantitative easing does not infer policy tightening, and that actual tightening is still on the distant horizon. Mr Bernanke further emphasised that policy actions will be conditional on incoming data. So, tapering does not mean a severing of the lifeline – Bernanke is sensitive to the need for reversal if change is imposed too soon.

It is safe to say that interest rates will remain low for longer as the current low interest rate is enabling the afore-mentioned recovery of the vehicle and housing industries. For those investors who are concerned about a repeat of the 1994 bond sell off, when yields rocketed by 220bp’s, they should remember that it was due to deliberate policy tightening when rates were hiked by 300 basis points in one year – on the back of a very strong economic recovery.  Current conditions are far off from those that prevailed back then.

When it comes to the signal for tightening, all eyes will be on the unemployment figure. The Fed’s target of a 6.5% unemployment rate for considering outright monetary tightening is unlikely to be reached before deep into 2014, or possibly only in 2015. Unemployment is currently at 7.6% and, as more people become active job seekers, will likely get worse before it gets better.

In the centre: Eurozone
Recession has settled like a mantle over the beleaguered Euro area but, while it remains to be seen if Spain and Italy will need rescuing, there have been some tentative signs of recovery, with Germany in the lead. The European Central Bank (ECB)’s policy of ‘we’ll do whatever it takes’ has recently been enhanced by forward guidance for interest rates – whereby the ECB has stated that interest rates will remain low for as long as it takes to get the economy growing sustainably.

Looking east…

Japan
In the east the sun is still rising on Japan’s Abenomics which, in the moment, seems to be panning out, but its sustainability remains in question. This three-pronged programme that aims to drive (and maintain) inflation to 2% is two thirds implemented, with fiscal and monetary stimuli already at play. However, the jury is still out on the ability (and will) of the authorities to implement the third prong – the growth strategy which involves deregulation, micro reforms and increased infrastructure spend.

China
If the Chinese growth story has kept the global investment community riveted, it is fair to say that recently there has been an increased preoccupation as the world’s fastest growing economy begins its transition from an investment driven economy to a sharper focus on consumerism, and the resultant decline in growth expectations. There have been clear messages from the Chinese authorities that their economy is not going to continue to grow at the 10% per annum, which it averaged between 1980 and 2010. They are happy with slower growth and expect to average 7% p.a. for the rest of the decade.
Many economies, ours included, have been hard hit by this slowdown – given the impact of this on commodity prices and therefore on the currencies of commodity exporters. But, Chinese policy makers are satisfied with a slower pace because they want to ensure that growth is sustainable and driven more by consumer spending and less by investment spending. This does not mean that the Chinese economy is going to collapse, and it is worth remembering that 7% annualised growth is well above that expected from its emerging market peers, as well as developed world counterparts.

Down south: South Africa
It is all about the rand right now. The local currency has weakened dramatically since the beginning of the year, plunging by 18% against the US$ to end June. There are many reasons for this weakness – including SA-specific factors as well as external factors which have negatively impacted the ZAR as well as other EM currencies.

The latter includes the impact the Chinese slowdown on commodity prices and related export volumes. Given that resource exports comprise over half of SA’s total exports, these conditions always impact the ZAR.  In addition, the prospects of the Fed’s QE tapering have created the impression that emerging market investments are now less attractive. Add SA’s internal woes to the pot, and it is easy to understand the sharp decline of the rand.

We have seen a definite slowdown of flows into our bond market, and we believe that it is thanks to the cheap rand that a sell off is unlikely, in spite of the current risks on the table. Especially in light of foreign ownership of government bonds is around US$47 bn and US$250bn of our equity market, while SA’s forex reserves are US$50bn, it is not a comfort.

Why has SA lost its appeal as an investment destination?
Slow growth and the inability to accelerate growth on a sustainable basis means that our unemployment rate is unlikely to shift from its perennial 25%. Implicit in this is ongoing delivery unrest and a volatile labour market.

Then there are the systemic issues such as our twin current account and budget deficits; the upcoming elections, which have hamstrung delivery and electricity shortages.

The large current account deficit is a concern but the depreciation in the currency over the last two years should help in reducing the deficit closer to closer to 4.5% of GDP over the next two years. The still-large budget deficit looms a bit larger with a slow-growing economy which increases the prospect of tax increases, which, in turn, will be a further drag on growth.

No silver bullet, but there is always a silver lining…
SA’s current slow growth environment is set to continue for the rest of this year.   While we do expect a substantial rebound in Q2 GDP growth from a very weak Q1 (on the back of the swings in mining and manufacturing production and distortions caused by the shifting Easter weekend), we still expect GDP growth this year of only around 2.1% – from 2.5% last year.  However, we do expect a recovery towards 3% + next year.  While the consumer is under pressure, we do not expect a slump in consumer spending similar to what was experienced in 2009. The consumer remains cash-strapped, which, paradoxically, has positive implications for inflation.

Historically, a weaker rand has a 20% pass-through to inflation, i.e. every 10% fall in the rand caused inflation to rise by 2% on average over the next two year period.  However, the weaker economic growth that we experiencing currently will limit this pass through because producers and retailers will find it more difficult to pass on price increases consumers. We expect this pass-through to be less than 10% this time around. In addition, food and oil inflation are better behaved than in previous inflation up cycles.

And, because the South African Reserve Bank (SARB) is more concerned about downside growth risks than upside inflation risks, we expect rates to remain flat through the remainder of the year and most, if not all, of 2014.

It always pays to keep things in perspective, and it is worth reflecting that SA has made significant progress since 1994:  peaceful political transition and several successful elections since; economic policy is reasonably pragmatic and major economic restructuring has occurred – inflation is lower, fiscal disaster has been averted and infrastructure has improved;  there is increased provision of electrification, water and formal housing and we have proven our mettle by  participating in major events such as the hosting of the soccer world cup.

 

 

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