Macro economic commentary – March 2019

Author: Morotola Pholohane | With the world economy widely expected to decelerate, a growing number of central banks are delaying normalising their monetary policies. The stalled pace of policy normalisation is designed to combat advanced economies from falling into economic contraction. Indeed, liquidity was looser in the first quarter of 2019. The money supply data of significant economies such as the United States (U.S.), China, the Eurozone and Japan, shows that central banks pumped almost $1tn into global markets. This partly explains the rally of riskier assets such as equities and bonds in the first quarter.

The closely monitored U.S. yield curve gradient inverted for the first time since 2007, leading to the speculation of a possible recession of the American economy. The spread between the 10-year and 3-month Treasury yields went negative, and historically, an inverted yield curve has tended to be associated with a higher probability of an economic downturn in coming months. However, a healthy U.S. labour market coupled with rising wages is propelling the American economy to what seems to be the second highest post World War ll expansion on record. Wages are higher among lower income earners, which should directly fuel consumption growth. Persistent strength in the labour market is not supportive of immediate recession risk. Furthermore, an increase in the marginal dollar of income has a more immediate impact on consumption when it comes from the lower income earners because of their lower propensity to save.

During the previous recession period, the U.S. saving rate fell. This time around the savings rate has been stable and improving especially in the post-2013 period. Household leverage as both percentage of net worth and disposable income, has decreased sharply since 2009, contrary to past recessions. Debt service ratios have been constant even in the recent interest rate hiking cycles of 2016 and 2017. Delinquency rates for most loans such as autos, mortgages and credit cards have fallen sharply since 2010; however, there has been some weakness in the credit card data since 2017. Apart from student loan delinquencies, which are quite high, the obligation ratios are still constant for most households.

The underlying condition of the U.S. consumer seems to be healthy and able to withstand a severe recession. Inflation is still very low implying that the rising wages have not created any inflationary pressures in the system. Real per capita income is feeding consumption but not at a sufficient pace for the service inflation to offset weakness in goods prices from a strong dollar. A strong dollar is holding back demand for American goods domestically in favour of imported goods. The inflation rate is still hovering below the U.S. Fed’s inflation target of 2 percent. In the recent Federal Open Market Committee (FOMC) meeting, the Fed’s guidance was to remain cautious and patient with respect to further interest rate tightening.

The fourth quarter GDP for the U.S. was weaker at 2.2 percent, compared to the previous quarter of 3.4 percent. Personal consumption, fixed investments and private inventories contributed positively while net trade, and government spending detracted. Overall annualised GDP growth for 2018 was 2.9 percent, the highest since 2015 compared to 2.2 percent in 2017. Only net trade contributed negatively to the GDP in 2018 while public spending was positive notwithstanding the negative contribution in the fourth quarter of 2017 due to a partial government shutdown in December. Looking ahead, growth is marked down in 2019 in anticipation of slowdown and fears of recession. Consumer confidence is on an upward trend since the beginning of the year as measured by the University of Michigan, at 91.2, 93.8 and 98.4 in January, February and March respectively.

While it is not gloom in the U.S. economy, there is a high level of uncertainty in the global market that can impact the U.S. economy negatively. Firstly, the jury is still out in terms of the negative impact of U.S.-China trade wars. Secondly, Brexit is unfolding almost every hour. Thirdly, within the European Central Bank (ECB) there is key-person risk looming with three of its executive board members stepping down this year, including its president Mario Draghi. And fourthly, political and macro-economic risks in EM countries such as South Africa are elevated. South Africa is going into elections soon, amidst electricity grid challenges and a weakening fiscal position. The market will try to re-adjust prices as these events unfold including the EM markets.

In the Eurozone, ECB President Draghi asserted that the risks to the economic outlook remain elevated, while inflation remains moderate. This has allowed for a continued accommodative monetary policy that includes negative interest rates. European bond yields fell below the zero mark in this first quarter of 2019, just three months after the lows in the stock market. The ECB has been facing negative rates since June 2014, and the current interest rate is negative 0.4 percent. The compression in the term premium component of long-term interest rates has continued, and there are arguments in the from investors for the need to soften the impact of the negative rates. Recently, the ECB President has indicated that the central bank will assess the effects of negative deposit rates on the banks. However, the ECB does not see low profitability of the banks as a complete consequence of negative rates. The ECB continues to monitor how the banks can maintain healthy earnings conditions while net interest margins remain compressed. Further, the ECB will investigate possible measures to mitigate the side effects (if any) of negative rates for the economy at large.

Previously, the ECB has rejected a tiering system as a possible tool citing complexity, but the central bank’s new tone is of considering viable alternatives. The tiering system is not new; other countries such as Switzerland, Japan and Denmark are already using it. In a tiering system, some reserves of the institutions held at the central bank are excluded from the penalty of negative rates. The tiering system has been used to achieve different objectives in most of these countries. In Denmark, first introduced in 2012, the aim was to weaken the currency. In Switzerland, the authorities intervened to save its currency from Russian inflows and weakening Euro. While the latter two countries are operating a two-tier system, Japan operates a three-tier system where existing balances at the Bank of Japan before tiering commenced are paid 0.1 percent; then a zero percent rate on required deposits; and then a minus 0.1 percent rate on all other balances.

The Chinese economy is still slowing down but at a decreasing rate. The Bloomberg consensus forecast for the GDP growth rate is being revised downwards for 2019 to 6.2 percent with the lowest estimate of 5.9 percent and highest of 6.8 percent.

The fiscal support put in place and loosening monetary policies to cushion economic slowdown seems to be coming through the financial system if the indicators are to be believed. The data is pointing to small and medium enterprises (SMEs) picking up steam based on the Standard Chartered Small Medium Enterprises Confidence Index (SMEI). Notably, the credit index is recovering as both production and new orders appear to be breaking higher. The new developments are encouraging given that much of the stimulus was targeted at the SMEs. The latest Purchasing Managers’ Index (PMI) in February was disappointing, at the three year low of 49.2; however, if history is to be trusted, the turn in the SME data should flow through to a favourable PMI reading in coming periods. Export orders were most hit, reaching their lowest point in 10 years, showing the fragility of global demand. New orders were up, suggesting stimulus is slowly starting to boost domestic growth. The Chinese authorities’ goal is well known – to grow domestic consumption and reduce reliance on trade exports.

Government investment in infrastructure has started yielding a positive impact on the economy. This was reflected in the growth witnessed in the steel and construction sector of the economy for the first quarter of 2019.

The worst-case scenario predicted by Bloomberg from the trade negotiation seems to have softened as the U.S. and China negotiators are continuously dining with each other in what appear to be tough negotiations.

Elsewhere in EM economies, Turkey’s economic woes put the EM bloc on the centre stage resulting in an unusual currency market reaction in some countries with high betas like Brazil and South Africa (SA). For SA, the domestic equity market was favourable despite Turkey’s woes. Investors might view EM as a bloc but not as a homogenous market. The question to the investor’s mind is whether the current Turkish lira volatility will cause the global contagion that results in an EM crisis. EM has become more integrated into the global financial framework, and financial conditions have since evolved compared to the distant past. One could argue that EM financial markets are more established, diverse and resilient to withstand some external pressures currently than historically. The volatility in Turkey can reasonably be expected to have some impact on other markets; however, unlike earlier crisis in the late 1990s, when the meltdown in the other countries caused infection to the entire region or other EM countries, the impact will be less. The South African Reserve Bank (SARB) governor indicated that previous episodes of crises did have more impact on the EM, including rand weakness compared to less reaction in the current event.

Global investors remain hungry for higher yield and their willingness to invest should still support EM countries with good fundamentals. Capital flows in the first quarter of 2019 were favourable in some countries despite volatility (in countries like Turkey). Either investors are seeing better relative-value to developed markets or renewed, specific, positive sentiment towards other high-yielding EMs.

In SA, stage four electricity load shedding in the economy will likely impact growth and business confidence if it persists in the coming months. The constrained power supply likely to limit production as well as commitments to invest. Retailers are already reporting a considerable number of hours lost due to load shedding. Business operating costs are increasing with the use of alternative energy as a result of electricity blackouts. Small and medium businesses are expected to be worst hit as the country continues to struggle with stabilising the power grid. This development might endanger employment and increase economic growth risks. It is not all doom as the electricity intensity per unit of GDP has been declining over the years attributed to efficiencies and alternative energy sources. The latest Stats SA quarterly unemployment rate did show slight improvement, from 27.5 percent to 27.1 percent, largely due to an uptick in seasonal jobs over the December holidays.

The inflation rate is lower and comfortably within a targeted range, as well inflation expectations remain contained. The latest inflation printed in February was 4.1 percent, lower than the mid-point of SARB, and slightly higher compared to 4 percent in a prior month. Fuel prices rebounded (-1.2 percent year-on-year previously to 0.9 percent currently). Higher food, transport and energy prices are the risks in the near to medium term; however, decreasing labour costs could offset it.

GDP growth accelerated to 1.4 percent in the fourth quarter, with overall GDP averaging 0.8 percent for 2018, lower compared to 1.3 percent in 2017. For the same quarter, gross fixed capital investment contracted, and inventories experienced significant drawdown. Household consumption was robust while net trade was negative. Government consumption contributed positively.

The SARB, in its recent Monetary Policy Committee (MPC) statement, noted that economic growth is at a slower pace than previously anticipated. It could be argued that MPC misjudged the economic conditions when it tightened its policy rate in November 2018. In line with the prevailing economic conditions, the growth was revised downwards throughout the forecast horizon, to an annualised rate of 1.3, 1.8, and 2 percent from 1.7, 2, and 2.1 percent for 2019, 2020, and 2021. The SARB left rates unchanged in the latest MPC meeting.

Moody Investors Services left South Africa’s credit ratings unchanged for now, providing some short-term relief as the country remains included in the WGBI investment grade basket. It is, however, important to note that the fiscal outlook has not fundamentally changed to diminish any downgrade risk in the foreseeable future. This improves the outlook for bonds in the short to medium term. The downside risk of equity may be on the periphery.