Macro economic commentary – March 2018

Author: Ntsekhe Moiloa.

While the local equity market suffered a wobble in the first half of February alongside global equity markets, it did recover most of its losses by the end of February. For the first week of March, the recovery seemed to be intact but after roughly a month of recovering, equity markets capitulated again. While the February global sell-off was attributed to turmoil in volatility funds, the March sell-off has been attributed to retreats in large, global technology stocks as a data privacy scandal has engulfed Facebook in the main.

March proved to be no bed of feathers for equities locally either. The All Share index was down about 4.2 percent and the Shareholder Weighted Index fared even worse with a fall of 5 percent. Offshore, the Japanese Nikkei 225 index had a negative total return, down about 3.5 percent, while the American S&P500, the German DAX and the French CAC were all down between 2.5 and 2.75 percent.

Certain market technicians have suggested that unless American markets break below the February low, we are unlikely to have entered into a bear market. Our sense is that American markets will struggle to push higher, even if they do not break below the February low in the near term. Similarly, we have the sense that April will trade with a slight downward bias locally, until we see economic data releases that suggest a stronger economic recovery.

Some economic commentators have expressed the worry that rising global interest rates are a key factor in capping equity market performance. One is initially inclined to agree that policy rate normalisation is going to be a headwind for equities but on closer inspection we believe that misses a greater point. The cost of money is not the issue. Rates rising 10, 20, 30 or 50 basis points are not going to turn business owners off investing if the underlying economic momentum is good. It is really only when money rates are set to put the brakes on money supply that one should expect investment to slow down, and so far, there is no indication that any major central bank is trying to do this.

On the contrary, central banks are trying to quietly tidy their balance sheets without frightening capital markets. In the US, the Fed’s approach to balance sheet reduction has not been to sell securities outright but rather to allow them to mature without reinvesting. While this does not put explicit pressure on securities prices, it does make it more difficult for issuers to refinance when a significant investor withdraws buying support and a potential source of liquidity. Our description deserves qualification though; the Fed has an arrangement with the US Treasury that it will subscribe for replacement securities at a lower quantum than the securities that mature. For example, in February a total of USD 48.7 billion Treasuries matured and the Fed subscribed for USD 36.7 billion in new Treasury issuance.

In order not to scare market participants, the Fed is draining money according to a schedule published in September 2017. The schedule is well-known – true – but it is not as though the Fed has taken out Facebook ads to keep the public informed. During the February market correction, the Fed did not alter its adherence to its schedule. The schedule was to reduce holdings of Treasuries and mortgage-backed securities in a quarterly waterfall fashion: USD 10 billion per month in 2017Q4, USD 20 billion per month in 2018Q1, USD 30 billion per month in 2018Q2, USD 40 billion per month in 2018Q3, and then plateau at USD 50 billion per month in 2018Q4 and beyond. The US Fed would then be taking liquidity out of the system at a rate of USD 600 billion per annum into perhaps 2020, unless something significant breaks in globally significant capital markets.

If something breaks, the Fed has said that its first order of business would be to lower interest rates. Unfortunately, when interest rates are around two or three or four percent, they are not high enough to be a deterrent to normal business. Zombie companies that survive only because of ultra-low rates may sputter and fail, but most enterprises should be more resilient and capable of surviving in a somewhat higher interest rate environment. Consequently, lowering the price of money is unlikely to be a sufficient counterbalance to the essential problem which we read to be the quantity of money. If policymakers make the error of focusing on the price of money rather than quantity of money in their initial response, the question for us as investors is whether the error would be a persistent one. We think not.

We think that the Fed would look across to the other side of the Atlantic and note that while the ECB is slowing its quantitative easing program with the intention of wrapping it up probably around the end of this year, they have not packed away their tools yet. The Fed would also note that the UK’s GBP 435 billion quantitative easing program is very much in place since the Bank of England has indicated that the current policy rate of half a percent would need to rise closer to 2 percent before the program is unwound. Further afield the Bank of Japan remains committed to supplying net liquidity over the medium term.

In another corner of the financial markets we find a further indication that it is not the price of matter that matters, but rather the quantity; contingent convertible bonds (better known locally as additional tier 1 bonds) in Europe appear to be suggesting that the capital adequacy trigger points at which they convert to equity are too low and perhaps not even material. Smaller banks that have had to be rescued appeared to be trading normally and with excess capital levels when they suddenly could no longer access liquidity.

It seems to us that alertness to exceptional central bank measures remains the order of the day. Additionally, we face the possibility that the trajectory of interest rate increases may slow down. Having said that, it has not all been one-way traffic in interest rates around the world. Locally, the South African Reserve Bank’s monetary policy committee lowered the policy rate by 25 basis points. Risks to the inflation outlook were considered to be evenly balanced. Questioned about whether the most recent VAT rate increase was taken into account, the SARB Governor responded that VAT could have increased the inflation outlook by O.6 percent. That the outlook is lower reflects the MPC’s view of the demand impact of the increase. Overall, demand pressures in the economy do not pose an upside risk to inflation. In the MPC’s assessment, risks to its growth forecast are to the upside which reflects the committee’s conservatism in its growth projections. Yet it was not an extreme conservatism if one considers that there was no discussion of a 50 basis point cut; in fact, 4 members of the committee preferred a reduction while 3 members argued for an unchanged stance. One and done then.

It remains to be seen whether South Africans will be tempted by a slightly lower price of money to spend, especially a price that is unlikely to go lower. Consultants assisting the retail industry with credit rating potential customers suggest that on the margin it is the ease of accessing money that is a better motivator to spend than the price of money. These consultants report that regulations designed to protect consumers have added friction to the transaction process with the perverse result that the most credit-worthy customers do not bother to file the paperwork required to obtain credit. While interest rates are lower, administered prices such as water tariffs and other municipal charges are keeping households under pressure. There is no American-style tax break for South Africans. On the contrary, South Africans face a higher VAT rate for the foreseeable future. The worry for investors in rand revenue shares is where the next leg of profitability will come from. At about the same time that Donald Trump worries about getting his Wall built on the southern US border, local and global investors are battling to break through a wall of worry that the bull-run in equities and bonds has finally run out of steam. Increasingly one reads or hears murmurs to trim exposure into rallies.