Macro economic commentary – April 2018

Author: Tony Bell.

Global growth: recovery remains in place but slowing

The dominant investment “story” since 2016 has focussed on the extent of economic growth coupled with the “normalisation” of interest rates in the US and Eurozone following the extraordinary stimulus measures introduced in the wake of the GFC (global financial crisis in 2008).

Entering 2018, the global economy has been trying to adjust to a range of opposing forces: low interest rates in most developed regions, tax cuts in the US and continued monetary policy stimulus in the Eurozone and Japan. These have been partially offset by rising bond yields in the US, higher oil prices and capacity constraints leading to higher wages and higher inflation in the US. Both developed equity and bond markets reflect this dynamic with US 2-year treasury yields rising above 2%, 10-year yields above 3% and the S&P500 is 8% below its January peak. Oil prices have risen by 43 % over the past year while forward yields in the US point to a higher level of inflation down the road. In simple parlance, global economies are shifting gears to a lower, more sustainable, growth trajectory.

For the U.S. economy, there is nothing suggesting that the business cycle expansion will run into major trouble, but the rate of economic expansion may soon cool from the swift pace of 2017. Higher borrowing costs and rising energy prices may start to restrain the economy. Increasing political and policy uncertainty over President Trump and his administration might have also partially offset the optimism spurred by tax cuts. At present, the U.S. economy is probably expanding at a peak rate and this should be followed by a reset phase, allowing the economy to transition from growth acceleration to a lower but more sustainable rate.

Despite the downside surprises, there are no major catalysts that will abort the business cycle in the Eurozone for the remainder of 2018. Consumer confidence remains strong, retail sales are holding up well and the ECB (and BOJ) are in no rush to normalize monetary policy. Japan has a slightly more challenging issue to deal with, being that of persistent deflation. Despite numerous attempts, Abe’s policies have failed to nudge the price of goods and services higher. More QE is indicated. China has delivered better-than-expected real GDP growth during the first quarter. Private capital has now surpassed state sector investment growth, consumer spending is firm, with the service component of GDP continuing to grow at a double-digit annual rate. All of this implies that the economy is building endogenous growth momentum, with consumer spending and the service sector driving the economy.

US bond yields: any hidden message?

In previous reports we highlighted the potential for US bond yields to rise as capacity constraints, higher wages and normalisation of monetary policy all contributed to a normalisation of the yield curve. Given the relatively low growth trajectory of the US economy the sharp rise in the short end of the yield curve has come as a bit of a surprise. With a difference of just 50bps between 2 and 10-year yields, the question needs to be asked whether the US is slowing more rapidly as a flat to inverted yield curve has, historically, been a good predictor of an economic recession within 18 months. A flattening yield curve also suggests that, although the Fed is upbeat on the U.S. economy and is preparing markets for more rate hikes, long-term bond markets do not believe that U.S. nominal GDP growth will accelerate any time soon. The equity market correction year-to-date seems to confirm this view.

Dollar weakness: likely to persist?

While the U.S. economy remains strong, relative weakness in the rest of the world is already evident. This should limit the downside for the dollar for the time being. The dollar is also likely to find support through interest rate differentials as the ECB and BOJ have indicated that they are in no rush to raise rates. This, coupled with a weaker growth trajectory for the Eurozone and Japan is likely to translate into a weaker euro and yen. Nonetheless, from a secular viewpoint, the dollar’s bear market does not seem to be over. The dollar is still expensive against most other G7 currencies and the broad real effective exchange rate is still above its fair value.

Domestic outlook: any improvements in sight?

South Africa’s prospects have improved – but just slightly. Real gross domestic product (GDP) accelerated to an annualised rate of 3.1% in the fourth quarter of 2017, marking the third consecutive quarterly growth rate above 2.0%. Most of this growth came from the secondary (manufacturing) and tertiary sectors (financial, wholesale, retail and motor). By contrast, output growth slowed notably in the primary sector, largely due to a contraction in mining output. Growth in real agricultural output also slowed somewhat. Encouragingly, consumption expenditure by households and the change in inventory holdings contributed the most to real GDP growth in the fourth quarter of 2017, while gross fixed capital formation also contributed positively for the first time since the fourth quarter of 2016. The turnaround in private capital investment was driven by significant outlays on machinery and transport equipment.

Inflation declined sharply throughout 2017 to below 3.8% in March 2018. The moderation in inflation resulted largely from a reduction in supply side cost pressures amid relatively subdued domestic demand. In particular, food and electricity price inflation slowed notably, while the appreciation in the exchange value of the rand since early 2016 lowered the prices of imported goods significantly. As a result, core inflation receded further to its lowest rate in more than six years in January 2018. South Africa’s trade surplus with the rest of the world narrowed in the fourth quarter of 2017 as the value of merchandise imports increased more than the value of net gold and merchandise exports. The net inflow of capital on South Africa’s financial account of the balance of payments increased notably from the third to the fourth quarter of 2017, driven largely by significant net portfolio investment inflows. For 2017 as a whole, the acquisition of domestic debt and equity securities by non-resident investors almost doubled compared to 2016, reflecting the global search for higher investment returns.

The rand appreciated significantly from around mid-November 2017 to the end of February 2018; first after an international credit rating agency downgraded South Africa’s local-currency debt but another rating agency put the country’s credit rating on review instead of an immediate downgrade, and later in response to the outcome of the African National Congress’ (ANC) elective conference in December and the subsequent, positively perceived domestic political developments. In step with the marked appreciation in the exchange value of the rand, domestic money market rates and South African government bond yields declined notably over the period, reflecting improved investor sentiment and lower domestic inflation expectations.
Against this backdrop the 2018 Budget Review proposed a number of measures to rebuild confidence and to return public finances to a sustainable path. These included various tax increases, most notably the first increase in the value added tax (VAT) rate in 23 years, and a marginal reduction in the expenditure ceiling.

Yet more needs to be done. SOEs need to be recapitalised, government departments right-sized, wasteful expenditure curtailed, corruption rooted out, fixed investment spending increased, tax dispensations granted for foreign investment among many other policies.