Macro economic commentary – Nov 2017

Author: Ntsekhe Moiloa

Source: San Francisco Federal Reserve

In his confirmation hearing at the end of the month, nominated US Fed chairman, Jerome Powell, said that the case for a rate hike in December is finally solidifying. A part of the hesitancy in raising rates in the US (and even in the EU) has been a concern that inflation has not been high enough. Central bank policymakers have worried that this may point to underlying demand weakness that might be further hindered by higher interest rates. Apologists for low rates have suggested that inflation was relatively subdued because of a variety of plausible reasons including labour market slack, declining oil prices, and dollar weakness. In a letter published at the end of November, economists at the San Francisco Federal Reserve Bank point out that the dollar has been strengthening and the labour market is strong, while Brent oil is trading above USD 63 as opposed to USD 46 as recently as June. Yet American central bankers continue to suggest that inflation is mysteriously low. In essence, the researchers set out to find out whether the reason for low inflation is in fact a mystery. Delving into spending categories, their findings for the US are that medical inflation caps in Medicare are a key reason for subdued overall inflation. With that mystery resolved they imply that what looks like a lack of demand is not that at all.

Rising US rates are likely to be dollar positive, potentially improving the case for marginal asset flows to go into dollar assets which should at that point enjoy an improved yield. As with many things in life, the theory may or may not accord with reality. For instance, in addition to interest rate differentials, expected growth differentials as well as expected political risk differentials may factor into an investor’s view of the appropriate currency allocation to take. The Economist Intelligence Unit produces monthly political risk scores for a host of countries and it is worth mentioning that for all of the perceived dysfunction in American politics, the US political risk score is better over the past several months relative to South Africa, Turkey, France, Germany and even China where there was little in the way of news apart from the proceedings of a ruling party congress.

Emerging markets have had a number of big political risk events in the past several weeks, ranging from China’s quinquennial Congress to Turkey’s arrest of American diplomatic workers. Closer to our region, the big news in November occurred in the second half as Zimbabwe’s military forced a peaceful presidential change, and South Africa’s local currency credit rating was moved into sub-investment grade territory by S&P Global Ratings.

Curiously, the rand weakened in the days preceding the announcement of the South African sovereign credit rating downgrade, and then strengthened considerably in the aftermath. Although it was essentially a split decision with S&P downgrading but Moody’s remaining unchanged, the effect was that South Africa will not fall out of the Citigroup World Government Bond Index – for now. The country’s local currency ratings would have to cross specific thresholds at both agencies; at S&P it would have to fall to BB+ and worse, while at Moody’s it would have to be worse than Baa3. After the most recent announcements, the S&P local currency rating is at BB+ while the Moody’s rating is on the cusp at Baa3. Since at least one of the two has technically not fallen through a threshold, the sovereign remains included in the index.

Source: Bloomberg, Standard Chartered Research

It seemed like a case of “sell the rumour [of an index exit], buy the fact” but could there have been a more convincing reason for the reaction? The strength certainly puzzled many currency watchers with some such as a Crédit Agricole strategist declaring that it was temporary and the rand would end the year much weaker. Other observers such as one Bloomberg writer contend that melting in the value of the rand and rand assets only serves to attract yield hunters in a global context where emerging market assets are in vogue, global developed market interest rates are generally low, and South African assets continue to offer relatively high carry. A number of other market observers made the argument that the rand strength has been off polls suggesting that Deputy President Cyril Ramaphosa is in the lead to succeed President Jacob Zuma as ANC leader. In short, no singularly convincing narrative has emerged, making any currency-centred trade a low conviction one.

There had been some expectation that the credit rating agencies would wait until after the ANC’s December elective conference before making an announcement. In the end Moody’s placed South Africa on ratings review, a process that starts the clock on 90 days within which the agency must come to a final decision. That 90 day window should be sufficient to incorporate the elective conference as well as the delivery of the country’s main Budget.

S&P Global Ratings, on the other hand, took the view that its core worry would be unaffected by either a change in the make-up of the ANC’s political leadership, or the budget. As the agency had stressed over the past several months, South Africa’s greatest challenge is and will be generating a rate of growth sufficient to fund its development and redistribution priorities. S&P essentially noted that the thrust of economic policy in South Africa has focused so much on redistribution that it has lost sight of the need to grow the economy.

A window of time in which the global economic backdrop could be supportive of South African economic growth appears to be slowly closing. On the penultimate Thursday of November the SARB’s Monetary Policy Committee issued its decision to keep policy interest rates unchanged. In its statement the committee noted that the outlook for emerging markets includes slowing momentum in the growth of China which has been an important marginal buyer of the world’s primary goods.

Beyond emerging market growth, global growth may be peaking, according to the OECD. The organisation expects global growth to peak at 3.7 percent next year before retreating to 3.6 percent in 2019. Notably Japan, China and the Eurozone which have been distinct drivers of the most recent global strength, are expected to have already peaked this year.

The Bureau of Economic Research at the University of Stellenbosch carried out its quarterly confidence survey of about 1,600 business leaders in the first three weeks of November, ahead of the ratings announcements by S&P and Moody’s. Business confidence in South Africa continued to be decidedly poor with the RMB/BER business confidence index registering a fourth-quarter level of 34 after a previous reading of 35. While the index level is not as a low the 29 registered in the second quarter of this year, it remains close to this decade’s low.

The SARB’s quarterly projection model suggests that interest rates could be nearly a percent higher over the next two years. It is worth pointing out that the SARB’s assumptions and forecast results are reasonably optimistic. For instance, they project a growing output gap which might be the case if potential output was rising. Or the SARB expects a narrowing of the current account balance over the medium term which might happen if FDI and portfolio investment flows improve; it is unclear that either should improve. In the context of an economy experiencing a low rate of growth, fiscal stress, a likely rise in tax burden, a likely rise in inflation, the cooling of global growth and no clear coalescing to a growth mind-set in the political class, there is cause to worry about South Africa’s finances and its capacity to maintain or improve current levels of social stability.

The country needs improved infrastructure in a variety of areas ranging from telecommunications to water supply to power generation to transport links. Yet, it can barely afford to fund any of the needs in these areas, to the irritation of its residents. Despite being shown a revised funding plan for Eskom in which the power utility aimed to borrow ZAR 52 billion instead of a previously intended ZAR 68 billion, S&P continued to take a dim view of the utility’s prospects in the debt markets. Its high existing debt service cost as well as its negative free cash flow have S&P worried that the company is headed toward a debt restructuring unless the sovereign steps in to shore up its liquidity. Needless to say, the sovereign is hardly in better shape.

Even in the face of a lowered funding requirement it is not clear that Eskom will find the investor support it needs. Locally there is a great trust deficit between institutional investors and the company as allegations of substantial corporate governance lapses continue to be aired in the media and in Parliament. While international investors have arguably been more forgiving than locals, we expect to start seeing more defensively constructed portfolios offshore, a development that we expect to be accompanied by a slowdown in the momentum of assets flowing into emerging markets. We note that emerging market surprise indices are tracking lower in a divergence with upward sloping surprise indices globally and particularly in developed markets. With those developments may come a reduction in risk appetite which could extend to the debt of emerging market entities such as Eskom.