Macro economic commentary – June 2018

Author: Ntsekhe Moiloa

| One of the primary conventions of financial theory holds that participants in an economy are essentially rational “wealth maximizers,” meaning that they will make decisions based on the information available to them in a way that is as reasonable as possible. However, in practice there are countless instances in which emotion and psychology have undue influence upon our decisions, and the result is that “rational” actors can and do display unpredictable or irrational behaviours. The branch of economics which is concerned with this paradox is called behavioural finance. Two of the key ideas embodied in the theory are “anchoring” and “framing”. Anchoring is a form of framing where investors use the past to map the future. But framing is broader in its remit than anchoring as the behavioural response within a complex world is influenced contextually. Anchoring tends to involve first order linear analysis that sets the future on a trajectory derived from the past. Framing tries to see the world in context. It is important to remember that both are biases to avoid as one attempts to evaluate geopolitics and the global macroeconomy.

The world, as we see it, is being shaped by two key dynamics. The first is multi-polarity, the second hegemony. More than seven decades years of relative peace after the Second World War, the rise of China, the collective improvement in many emerging economies, and the advent of the 4th industrial revolution have created a world that is no longer dominated by a single power. Looked at over time, BCA (Bank Credit Analyst) estimates that US domination (hegemony) has declined by a third over the past 20 years. China’s economic rise has preceded its rise in military power and has influenced its increasing dominance in regional affairs including its developmental interests in Africa and elsewhere where it seeks political influence, access to land and resources.

South Africa, for its part, is facing something of an existential crisis. Until recently Moody’s, the biggest of the international credit rating agencies, has been kind to SA. Unlike Fitch and S&P which have both downgraded SA to sub-investment grade, Moody’s has held back. Towards the end of June Moody’s put National Treasury on notice that its stance may well change when it releases its update on October 13th. Its change in position results from a reassessment of the position it took in December last year when it stated that “the confirmation of SA’s rating reflects Moody’s view that the previous weakening of SA institutions will gradually reverse under a more transparent and predictable policy framework”. In its latest update Moody’s cautions that the ongoing uncertainty linked to the ANC’s land policy is impacting investor confidence and flows. Given South Africa’s low savings rate, high levels of SOE debt and current account deficit, it is dependent on both foreign capital flows and domestic net investment. President Ramaphosa has established a task team to raise $100bn in new investment. Given the parlous state of the funding structure of SOEs we doubt that meaningful progress will be made in attracting new investment at this juncture as the “framework” simply doesn’t exist. At its most recent conference, the ANC tabled a policy framework that enjoined delegates to “dream” about a better future. As one is all too often reminded, “hope is not an investment strategy”.

Further afield President Trump is on a path that may end up seriously curtailing both America’s growth and its influence in a multipolar world as he too is ineptly framing his policy response to a rapidly changing world. In attempting to restore power to America, Trump campaigned to reverse globalisation (taking jobs away from Americans), adopt a zero tolerance to illegal immigration (too many “bad hombres”), and rectify Washington’s ineffective foreign policy. All interventions have, in true Trump style, been applied with maximum force. While this is not the first time a US president has followed both an aggressive trade and foreign policy, the difference this time is that, in a multipolar world, these actions tend to dramatically escalate the inter-state conflict. For now, US equity markets and the dollar seem to support the short-term benefits. But as Trump gets more addicted to “winning” he is likely to pick bigger fights. While Trump’s actions speak to his political base, they are unlikely to address the structural causes of America’s decline. What is more likely is that his policy will cause the rest of the world to react in unpredictable ways. As Trump moves to his next round of tariffs against China (from $50bn to $200bn), China’s proportionate response will cover more goods than the entire range of US imports. So, China will retaliate in other areas. Expect China to enter into a series of moves to devalue its currency as negotiations over trade tariffs falter. China is also expected to flex its muscle in the South China Sea. Aside from the trade war with China, Trump seems determined to take on European car makers at the same time. It is thus not surprising that he received a rather frosty reception at the G7 summit.

What, then, are the flags to monitor from a financial market perspective? The first flag is the so-called “central bank put”. Since 2008, central banks around the world have supplied unprecedented levels of liquidity to the global financial system. The “cookie jar” is being withdrawn by both the Fed and ECB. Yield curves are normalising to a degree with short-term rates in the US 30 basis points lower than the yield on long-term treasuries. While the US economy continues to deliver good growth, constraints in both the labour market and manufacturing sector are reaching a break-point in the current economic cycle. Almost full employment with more job openings than applicants in the skilled segment of the economy places upward pressure on wages. Higher wages lead to higher demand and higher prices in instances where capacity is constrained. Inflation could rise further, spurred on by higher energy prices at a time when the dollar may well have reached a short-term peak. Higher interest rates coupled with higher energy prices create something of a tax on growth, but current levels are not yet sufficient to derail the US growth vector. Yellow flag.

Earlier this year we noted something of a “freeze” in the interbank market as the LIBOR / OIS spread (London interbank offered rate / overnight indexed swap rate) shot up sharply. When this happens, it indicates that banks are reluctant to lend to each other as happened during the 2008 GFC (global financial crisis). While the spread has returned to more normal levels, the withdrawal of central bank stimulus coupled with heightened risk probabilities associated with geopolitical shifts could cause further freezes. It will be important to keep an eye on this spread as well as the gold price and VIX index. Yellow flag.

Turning to equity markets, we observe both a narrower market breadth and a very wide spread in price:earnings multiples between so-called “growth” and “value” stocks. What does this mean? After a number of years of well-above average returns, growth stocks with particular reference to those in the US are pricing in a high proportion of the natural earnings growth companies in this group can deliver. We take some comfort from the forward estimate for US earnings growth which remains robust. Absent a liquidity crunch it is hard to see a scenario where the current price-to-earnings multiple would contract to the extent necessary to catapult the S&P 500 into a bear market. What does concern us is the differential in performance between high growth stocks and the rest of the market. Narrower market breadth is associated with a mature bull market. Yellow flag.

Domestic equity markets have laboured over the past three years as economic growth evaporated. We were of the view in 2013 that domestic economic growth would remain below 2% for the ensuing five years and, indeed, we suggested that SA was at the first stage of structural decline. At the time growth was above 3% leading to a number of parties questioning the veracity of our estimate. Our current position is little changed. Domestic bank and retail stocks tell the story of a consumer who, at some point in time, had the capacity to spend. The reality today is very different. Somewhat paradoxically it would be extremely unwise for President Ramaphosa to implement “radical economic transformation” in order to correct the growth problem as this would greatly raise the odds of a policy failure ahead of next year’s election, and, if successful, would lessen the need that the governing party has for him as the bridge to winning the 2019 elections.