Dark clouds and silver linings
In its biannual Monetary Policy Review, the SA Reserve Bank (SARB) describes the outlook for the global economy as “sunny with a chance of storms”. Perhaps the current mood in South Africa can be described as “stormy with a chance of sun”. The dreaded R-word, recession, is being thrown around following the first quarter’s contraction.
We are probably not headed for a recession, but unfortunately we have little to buffer us against any shocks. The biggest risk to the economy at the moment would be a rapid rise in inflation due to a further sharp depreciation of the rand, forcing the SARB to hike rates. Given the weak state of the economy, it won’t take too many rate increases to push us into recession.
The rand is the key factor
The rand has lost more than 4% against the US dollar over the past two weeks, following losses experienced by other emerging market currencies. However, the rand fell further than our peers, pointing to investor unease over South Africa’s growth outlook and widening trade deficit. But investors should keep in mind that the rand has fallen 60% over the past three years, and is already undervalued, limiting potential further depreciation.
The weak rand should also be part of the adjustment process, limiting imports and stimulating export growth. Unfortunately this process has been disappointingly slow. The trade deficit is also not helped by the fact that commodity prices have fallen back, especially iron ore (-30% yearto- date) and coal (-11%), which are two of our major exports. Overall, import prices are still rising faster than export prices and for the trade deficit to close, import volumes will have to drop.
Meanwhile a ratings downgrade may be on the cards, as early as this week, leaving South Africa just one step away from no longer being considered as ‘investment grade’. The ratings agencies have long expressed concern over South Africa’s low growth rate. Lower growth usually means lower tax revenue for government, which limits government’s ability to close the budget deficit. Recent tax revenue numbers have surprisingly been buoyant, but if this trend turns, the Treasury could be forced to increase tax rates. This would not be an ideal way for the new Finance Minister to introduce himself to the country.
There are silver linings
For some perspective, consider that it is not just South Africa where things seem gloomy: on the eve of the FIFA World Cup, Brazil’s economic growth forecast for 2014 was downgraded to only 1.5%. Brazil has similar challenges to South Africa: reliance on mining at a time when commodity prices are falling, inequality, infrastructure constraints, corruption, and a private sector restricted by red tape.
More importantly, the global economy is still growing, led by the US. While we certainly have our problems, our economy tends to follow the global cycle and the global economy is expanding, although at a modest pace. The European Central Bank’s (ECB’s) decision to charge negative interest on deposits banks place with it and also cut its policy interest rate to 0.15% is unlikely to make a big difference by itself, but is a step in the right direction. It could mean further stimulus measures as inflation is only a quarter of the ECB’s 2% target. Either way, the Eurozone’s economy is also growing, although slowly but adding to global growth for the first time since 2010.
For investors wondering how to navigate this environment, a diversified portfolio offers the best protection against a weak rand and fragile economic outlook, while still being positioned to beat inflation over the long term. Local equities tend to be rand-hedges, while the shares that generate the bulk of their earnings locally already price in a very weak economy. Bond yields have also increased considerably over the past year and are pricing in higher inflation and further interest rate hikes. Most balanced funds are fully allocated to global assets, especially equities, where the prospects for inflation-beating returns appear best.
