Macro economic commentary – July 2018

Author: Morotola Pholohane

Global trade tensions that prevailed in the month of July do not appear to have rattled investor confidence as one would have expected – market volatility indicators remained subdued during the month of July, ignoring much of the trade war noise. The VIX “fear gauge” and the CS Fear barometer, as well as most emerging markets’ volatility indicators, drifted lower or remained flat during the month. The subdued market volatility could be an indication of a market fatigued by all the rhetoric on trade wars. The BofA Merrill Lynch Market Risk indicators, which assess expected swings implied in global capital markets, suggest that global financial systems do not appear to be in distress. It would appear that known risks to the global financial system – such as the advent of trade wars, Brexit, normalization of global real interest rates and reversal of quantitative easing – are already priced into risky assets.

Financial systems at ease but economies at risk – trade is the biggest risk to global GDP

President Trump ascended to power in 2016, promising Americans to redress an unbalanced trade relationship with the rest of the world. As part of delivering on his promise, the world economies continue to be confronted with “more bite” on the escalation of trade wars. Although most focus in terms of impact has been on China given the scale of its global share of exports, the global growth risk emanating from further trade threats is of a large scale to almost all economies given the interconnectedness of international trade. It is estimated that the costs to global GDP will be 0.5 percent in 2020. The OECD estimates that China’s GDP would fall by 0.3 percent while other Asian economies would also be heavily impacted, shrinking by 1.1 percent due to the supply value chain. Moreover, exports from China contain inputs from countries like Japan, South Korea, and Taiwan. Most countries in the African continent, South Africa included, are major trading partners with China and export goods such as commodities to Asia, thus the escalation of the trade wars will be harmful to their economic growth. All these economies would likely share China’s pain if China’s exports to the US fall in addition to their own tariffs imposed by the US.

This narrative suggests that there might not be any winner in the trade wars if some countries retaliate aggressively with protectionist policies of their own. Furthermore, currency wars may re-surface and volatility in the global financial market system would increase. Consequently, performances of risky assets such as emerging markets may come under pressure. Countries running large trade and current account deficits as well as low savings rates, including South Africa, are most likely to be adversely impacted because under this scenario such countries are exposed to an increased risk of a ‘sudden stop’ in portfolio flows which fund the deficits. A sudden stop event (liquidity event) could lead to severely curtailed growth, sharp depreciation of currencies against the majors, and a rise in domestic capital markets’ volatility. In the meantime, China’s yuan has depreciated modestly “although more than normal” relative to the dollar in a move viewed as a response to US tariffs, despite weakening Chinese economic fundamentals including a slowdown in domestic credit growth.

The talks between President Trump and European Commission President Juncker seem poised for a more constructive engagement on trade as both parties have suspended new tariffs while negotiation is underway. In the event of an escalating trade war between the US and the EU, Slovakia and Germany would be most harmed within the EU, especially on their automotive exports to the U.S. Canada and Mexico are also in negotiations with the U.S. bilaterally and in tripartite through the North America Free Trade Agreement (NAFTA) bloc.

South Africa – in a state of policy flux

In South Africa, President Ramaphosa undertook to deliver foreign direct investment of over USD 100 billion in the next five years and went as far as appointing a Special Envoy to focus on this in April 2018. Since then the president has managed to secure about USD 35 billion worth of investment pledges (from China, Saudi Arabia, and the UAE), some of which will be used to capitalize the state-owned enterprises (SOEs) such as Eskom and Transnet. Furthermore, some of the investment pledged will be used for infrastructure development projects. The funding to Eskom and Transnet, which are the biggest sources of funding risk for the state, will alleviate short-term liquidity constraints of these parastatals, which has been a challenge to National Treasury in the recent past. These positive developments have led to an improvement in sovereign risk corroborated by the reduction in the South African 10-year CDS spread, which fell by 36 basis points during July. The good news notwithstanding, the South African government continues to be plagued by policy uncertainty which further underpins negative sentiment against the sovereign. Some of these lingering policy voids include: the nuclear deal allegedly entered into by former President Jacob Zuma, the land expropriation question, the mining charter, and the solvency of state-owned entities.

South Africa’s position on nuclear deal procurement and its impact on the country’s strategy to pursue an Integrated Energy Plan and Integrated Resources Plan. During the July 2018 BRICS summit in SA, President Ramaphosa clarified some question marks around the perceived Russia-South Africa nuclear energy procurement deal, clarifying that South Africa will pursue nuclear energy procurement only as and when it can afford to do so.

There is a vigorous public debate underway about land expropriation without compensation. The country is talking; from coast to coast people are airing their views and frustrations with existing land redistribution policy, others are highlighting risks associated with land grabs, and some point out that they fear that the land policy may lead to destruction of productive agricultural land. The point being, there is an ongoing “referendum” across the country on land policy and as the debate rages on, the much-needed clarity on land policy stance by the government remains an elusive subject. Furthermore, it remains to be seen what methods the government will come up with to solve this conundrum and satisfy all the stakeholders.

The latest mining charter has been gazetted but further consultations are still ongoing with both government and other mining stakeholders searching for the middle ground. The only positive aspect is that opposing parties are talking and willing to engage more constructively to come up with a binding mining charter that works for all.

The SOE funding model is still broken and finding a lasting solution to these ailing SOEs remains elusive. However, the government has managed to find some relief in the form of Chinese funding into Eskom and Transnet. These SOEs are a major source of risk to the sovereign credit rating as they continue to be the source of drawdowns to the fiscus. Government is considering several modalities to its funding structures that could reduce budget deficits including searching for equity partners for some of the SOEs.

Monetary policy has been the bedrock of constancy in government with the monetary authorities pursuing their inflation targeting regime independently despite occasionally spirited attempts to influence them. The policy framework has managed to anchor inflation expectations within the target range of 3 to 6 percent in the recent past. However, from season to season, wage negotiations continue to be a thorn on the side of the monetary authorities as unionised labour pursues its mandate of inflation-plus wage growth with the same vigour that the South African Reserve Bank (SARB) seeks to stabilize inflation. The pressure notwithstanding, inflation is still comfortably within the SARB’s target band. In the latest Monetary Policy Committee (MPC) statement in July, the SARB took a more hawkish stance citing several risks to the inflation outlook arising from developments in the global environment – these include higher levels of oil prices and the stronger US dollar. The central bank revised its growth forecast down sharply for 2018, from 1.7 percent to 1.2 percent, while raising its inflation projections for both 2018 and 2019 on a higher oil price assumption and a weaker rand but still within the target band, peaking at 5.7 percent in 2020. A rate hike now seems less likely given the continued undershoot of inflation and the expectations for weaker growth. This may change if the rand depreciates significantly. A rebound in domestic food prices could lead to an upward adjustment in the SARB’s inflation forecast, but a more extended breach of the ceiling’s target seems unlikely.

The key risk to inflation remains to the upside in our view and the source, also flagged by the IMF, is SA’s vulnerability to financial flows given its persistent current account deficit, which will likely feed through to currency depreciation. There has been some relief (according to the figures) on the trade account which was boosted by exports of precious metals and a huge drop (51 percent) in the import of vegetables. The temporary trade surplus should provide some buffer to the rand which has depreciated significantly in the year-to-date, reversing most of its gains following the ANC elective conference in December 2017. Other inflation risk factors that were apparent over the month include the latest producer price inflation print which projected an upward trend to 5.9 percent year-on-year compared to 4.6 percent year-on-year the previous month.

On the positive side, the latest World Economic Outlook (WEO) update for South Africa brought some relief to growth expectations as the shocking GDP of -2.2 percent in the first quarter of 2018 appears to be transient. Growth is expected to recover sufficiently in the second quarter of 2018 to avoid a technical recession. Although 2018 growth expectations have been dampened, a recovery in growth is expected for 2019 owing to a rise in confidence in the country’s new leadership as well as strengthening private investment.

The risk to the growth outlook emanates from lower consumer spending – which accounts for about 60 percent of economic activity – resulting from headwinds due to higher value-added tax (VAT) and rising fuel prices. That said, there is impetus to growth coming from growth in capital investments and government’s drive to reduce wasteful expenditure and improve efficiencies within various arms of government, including revenue collection.

The globe– in a state of tension

The U.S. economy remains in good shape: consumer spending which remains the dominant driver of US growth is strong, taxes are lower, unemployment is very low and other domestic drivers such as business investment remain poised to boost GDP growth further. Core inflation continues to hover around 2 percent which is low by historical norms in periods where GDP has exhibited growth of 4 percent. The economy is growing with no signs of overheating from wage pressures, high consumer inflation or aggressive interest rate hikes. It could be argued that the higher growth rate without a commensurate rise in inflation at a time where the economy has reached full employment, could be an indication that economic growth is being generated by technological advancements in production and the service economy which have led to a marginal increase in output without corresponding inflationary pressures. The manufacturing sector corroborates this thesis as the share of manufacturing jobs in the U.S. has been declining, while the gross manufacturing output is accelerating, attributable to an increased impact of technology on productivity gains.

In the Federal Open Market Committee meeting that began on 31 July, the US Federal Reserve left interest rates unchanged and cautioned that “further gradual increases in the target for the federal funds rate” would be consistent with the labour market and keeping inflation near the Federal Open Market Committee’s 2 percent objective. Writing for Bloomberg, Tom Orlik observed that a “combination of Federal Reserve tightening and tariff-induced overheating could put upward pressure on the dollar –which is likely the opposite of what President Trump requires to shrink the U.S. trade deficit“. In the circumstances a stronger dollar would imply a weaker yuan, something that would help ease economic pressure on China.

The Chinese economy is facing headwinds from deleveraging and trade wars. The latest GDP growth number decelerated in quarter two, but remains within the government’s “comfort zone”. A breakdown of GDP shows the positive contributions coming from the information technology sector, from leasing and from sectors that might be characterised as being key to the new economy. “Smokestack” industries such as construction, real estate, and agriculture underperformed. Capacity utilization increased, reflecting “GDP growth rate in line with its potential”. The export boom which was a key driver to its higher growth previously is now started to face headwinds, reflecting some diminishing competitiveness. China’s exports as a share of global export trade has always been higher post-2009, currently at 13.2 percent, compared to US (9.1 percent), Germany (8.2 percent) and Japan (3.9 percent). The impact will mostly be felt in the Chinese manufacturing industry, which is already struggling with shrinking orders and heavy debts amongst other things. The tariffs added to its exports will add greater burden to the industry costs and ultimately to the consumer.

The outlook for GDP growth is of a slower rate, and, as a result, the Chinese authorities took more proactive fiscal and monetary policies to stimulate domestic demand and facilitate economic rebalancing. The pro-growth policies appear to mark an end to President Xi Jinping’s deleveraging campaign of fighting credit explosion. The bank reserve ratio has already been cut 3 times in the year-to-date and credit policies have been relaxed.

In Europe, spare capacity in the Euro-area labour market is almost exhausted, wage growth is picking up and underlying measures of inflation are beginning to firm. It is against this backdrop that the European Central Bank (ECB) plans to bring asset purchases to an end by the end of this year. It would take a big deterioration in the data flow to change that outlook, and no such thing looks imminent. The market expects the economy to rebound in the second quarter before capacity bottlenecks and higher borrowing costs act as a drag on growth.

Narrowing in on Germany, the broader picture is one of an economy operating at slightly above full capacity. The market expects that this is likely to remain the case across the mid-term forecast horizon. Germany is running a sizable current account surplus, which should provide some buffer against trade wars.

The French economy has now more or less recovered from the Euro-area crisis and President Macron has enacted reforms that are injecting dynamism into the labour market and boosting potential growth. The unemployment rate could fall further without the labour market becoming overly tight, but wage pressure will continue to build, lifting underlying inflation.

The UK has softened its Brexit stance and has proposed maintaining the benefits of the single market for goods while going it alone in services. However, the UK proposal was rejected by the EU chief negotiator Michel Barnier, partly on the basis that the British proposal did not provide a viable suggestion on how the Northern Ireland border would work. If a deal such as the one between the EU and Canada is assumed (the Comprehensive Economic and Trade Agreement), then British economic output is likely to be about 2.5 percent lower by 2022 than it could have been had the UK had voted to remain in the EU. Inflation is slowing from its peak of 4 percent as the effect of Brexit on the depreciation of the pound fades. The consumer price inflation rate is expected to move below the target of 2 percent in early 2020.