Macro Economic Commentary – December 2019

Author: Morotola Pholohane |

The global economy in 2019 has been characterised by a notable slowdown, while at the same time avoiding a full-blown recession. There was a consensus view that a recession was due, which did not happen. Instead, the economy experienced both the longest bull market and economic expansion cycle in history despite the disappointing rate of economic growth. Global equity markets were relatively strong compared to the fragile markets of 2018. Much of the weakness has been attributed to the China-U.S. trade war, and the uncertainty that came with Brexit. The weakness has led to a shift from policy normalisation to policy accommodation. Central banks, especially in the Eurozone, China, and the US cut interest rates to counter an economic downturn and subsequent slump in manufacturing. Despite an extended period of stimulus, inflation continues to be underwhelming. Could it be the case that stimulus has become counterproductive? Some economists believe that structural forces such as ageing populations and sluggish productivity are amongst the main forces making stimulus ineffective. It could be that effective monetary stimulus requires a much more active role on the part of fiscal policy.

Global markets have risen despite evidence of global stagflation with weak synchronized growth, low inflation, very weak earnings, and very high debt. The strength of markets could be on the expectation of further quantitative easing, moving the focus from the macroeconomy as the primary market driver to cheap money. Curiously, growth remaining lacklustre could be good for financial markets due to the likelihood of further stimulus, resulting in falling bond yields.

The problem in some developed economies is not low rates or needing more liquidity but rather high levels of debt and excess capacity. Therefore, lowering interest rates further may make the economy less dynamic. Moreover, lower interest rates are more likely to put downward pressure on bond yields, which are already at record low or negative in some economies. The former Fed Chairman Alan Greenspan is known for holding off interest rates for some years because the economic expansion at that time was not leading to higher inflation. In contrast, US President Donald Trump has been advocating via Twitter for the policy rate to be dropped down to zero, so that the government could refinance the national debt more cheaply. Mr President’s motive is clear – to ease the effect of the debt burden that his administration inherited but to which he has also added. It is worth noting that he has increased military spending and awarded a massive tax cut to the wealthy, all of which has added to the national debt. Whether under pressure or by coincidence, in 2019 the Fed implemented dual stimulus – three interest rates cuts (totalling 75 basis points combined) and later in the year it increased its balance sheet to address the strain in the repo market.

The repo market dilemma is a clear indication that even the newly implemented supplementary policy tools designed to help steer Fed funds rates are likely to struggle; the Fed has continued to have to provide additional lending to balance the market as the banks continue to hold more funds than required. Prior to the global financial crisis banks used to hold close to minimum reserve requirements, making it possible for the old-style monetary tools such as interest rate policy and reserve requirements, effective. More recently, banks are cautious, carrying higher excess reserves even at central bank rates that are potentially punitive to their profits.

Global debt has grown significantly, resulting in debt saturation. Companies have taken more debt because it was so cheap, leveraging up at all levels. There have been more zombie companies all over the world, which may weigh on forward growth. The risks posed by these companies will probably lead to a continuation of accommodative monetary policy. In the Eurozone, the new ECB president Ms Christine Lagarde has already mentioned embarking on a review of the central bank’s strategy. The strategic plan will most likely focus on a new approach to inflation targeting, which has been “below, but close to, 2 percent” annual target, since the 2003 strategy review. It could perhaps be a fresh approach as the assumptions underlying most central banks were established a long time ago; however, economies have since evolved. For the Eurozone, a rebound in global business investment could help bolster its manufacturing sector and rescue its economy.

In 2020 politics will be amongst the most significant risk contributors for investors with the US elections likely to dominate, and EU and UK negotiating Brexit terms. The biggest challenge for investors is deciding how to get decent returns in a low returns environment without taking enormous risks. Red flags would be negative turns in unemployment numbers in developed economies and negative earnings revisions.

Domestically, South Africa (SA) faces the risk of losing its last investment-grade (IG) rating by Moody’s if the upcoming budget fails to meet expectations. The general market consensus of a downgrade is already priced in by the market; however, poor sentiment may still weigh on credit spreads if, eventually, a downgrade happens. The results will be the exclusion of the SA local-currency bonds from the IG indices. There will be no direct impact on the SA hard-currency bonds as they are currently excluded from IG indices. Also, energy uncertainty remains the most significant challenge to an already fragile economy, with Eskom having implemented stage six load-shedding for a short period in December. With the continuation of severe power cuts, there is less optimism on economic growth to pick-up meaningfully in the near future. The market consensus sees some grounds for interest rates cuts in 2020 given benign inflation and disappointing growth.

It might just be another busy year for the central banks around the world, with growth still uncertain but stabilising and fiscal stimulus assuming some of the burdens.