Quarterly market and economic review
Herman van Papendorp, Head of Macro Research and Asset Allocation at Momentum.
Sanisha Packirisamy, Economist at Momentum.
Quarter ended 30 September 2015.
Risk aversion rife in 3Q15
Global financial markets were roiled during 3Q15 by increasing “risk aversion” on the back of worries about the impact of China’s perceived faltering growth prospects and the approaching advent of a US rising rate cycle on the global economy. While the sell-off in financial markets was initially concentrated in the commodities complex and emerging market (EM) assets (stocks, currencies and bond markets), it eventually also spilled over into developed market (DM) equities once the broader feedback implications of weaker China growth on advanced economy activity was fathomed.
Chart 1: SA asset class performance in 3Q15 (indexed)
Source: INET BFA, Momentum Investments
As such, equity was the clear underperforming asset class during 3Q15. However, with the rand depreciating by more than 13% against the US dollar during the quarter, the local currency returns of all global and dollar-denominated asset classes received a major boost in 3Q15. This was very evident in the strong rand returns shown by the gold ETF, where severe rand weakness far outstripped the small dollar gold price decline in the quarter. The listed property asset class also benefited from the risk-averse conditions apparent during the quarter, bouncing back from a weak 2Q15 performance.
We expect both fundamentals and valuations to ensure global equity outperformance over fixed income in the coming years.From a starting point of expensive historical valuations, global bond returns are also fundamentally at risk from dissipating deflationary risks amid recovering global economies and the start of tighter US monetary policy later this year.
Laying the groundwork for US rate normalisation
When the 17 members of the US Federal Open Market Committee (FOMC) met in September to discuss the appropriate monetary policy setting, they were presented with mixed economic news. Although recent data confirmed the economic recovery underway in the US, question marks over economic and financial stability elsewhere in the globe clouded the interest rate decision. This caused the Federal Reserve (Fed) to hold off on hiking rates while awaiting sufficient evidence confirming that spillovers of tighter financial conditions elsewhere are not threatening the otherwise favourable domestic outlook for the US economy.
The Fed’s forward guidance report, more commonly referred to as the “dot plot”, suggests that 13 of the 17 members still expect a rate hike before the year is up. However, Fed rate expectations for the upcoming hiking cycle have once again moved closer to the more sanguine view of the market. The median rate expectation of the Fed’s top officials moved lower to 1.4% by end-2016, from 1.9% six months earlier, but remains notably higher than the 0.7% expectation of the market. By 2018, the view differs more markedly, with the market expecting rates to end 2018 at 1.6%, while the median Fed expectation sits closer to 3.4%.
Increasingly, focus is shifting away from the importance of the start date towards the extent and duration of the Fed’s interest rate normalisation cycle. In our view, an equilibrium (nominal) policy rate closer to 3% better reflects the downward pressure on trend growth prospects in the aftermath of the global financial crisis (GFC), leaving real rates at half the long-run average of 2%.
Both the International Monetary Fund (IMF) and World Bank have strongly voiced concerns over the costs of raising US rates too early. Similarly, The Economist points out rate-hiking policy errors by the Bank of Japan (BoJ) in August 2000 and again in 2006, which subsequently had to be reversed in response to falling prices and an impending recession. Likewise, the European Central Bank (ECB) misstepped once in 2008 and twice in 2011. Sweden’s policymakers also acted erroneously by raising rates too soon and too rapidly during 2010-11 and then cutting rates too slowly once the economy plummeted into deflation. The Riksbank has since been forced into taking unprecedented action by slashing interest rates into negative territory.
While most market participants currently view economic activity as expanding moderately in the US, there have been more intense discussions over when the Fed’s bold efforts to stimulate inflation will show up in the form of higher price pressures. Although headline inflation has continued to run significantly below the Committee’s longer-run inflation objective of 2%, the Fed projects inflation to reach 1.9-2% by 2017, while survey-based measures of longer-term inflation expectations have remained stable.
Moreover, higher core and services inflation suggest that there may be less excess capacity in the US economy than is assumed. Admittedly, muted commodity prices and US dollar strength could keep a lid on near-term inflation. Yet, rising rentals (due to a tightening housing market) and an uptick in wage inflation (as a result of diminishing slack in the labour market) should underpin higher rates of inflation going forward.
Fed Vice Chairman, Stanley Fischer, has noted the importance of staying ahead of the inflation curve given the time lag with which monetary policy affects the economy, while St Louis Fed
President James Bullard has warned against policy being on an “emergency setting” despite the economy “getting back to normal”. The Bank of International Settlements (BIS) also cautioned that holding interest rates well below their “natural rate” is likely to shore up imbalances over time.
Moreover, the Taylor rule (a monetary policy tool stipulating how much nominal interest rates should adjust in response to changes in inflation and output) suggests that rates should
currently be trading at 1.7% using an unemployment rate target of 4.9% and a real rate of 1%. In our view, the aforementioned arguments justify a modest interest rate hiking cycle commencing before year end.
While the Fed and Bank of England (BoE) are laying the groundwork for an increase in interest rates, the BoJ and ECB are likely to keep interest rates close to zero while continuing asset purchases (¥6.5 trillion/month and €60 billion/month, respectively) to target higher inflation and fuel economic growth. Even though a cyclical improvement appears to be underway in the Eurozone, as evidenced by reasonable growth in private domestic demand and a recent marginal easing in credit conditions, the investment cycle has been hesitant. The Organisation for Economic Cooperation and Development (OECD) has also suggested that benign oil prices, low interest rates and euro weakness should have translated into higher growth and inflation rates for the region. Accordingly, we do not expect the ECB to roll back their QE programme any time before September 2016, which is likely to drive the euro weaker against the dollar; in turn underpinning higher inflation and an improvement in export-driven growth.
Emerging market jitters
The BIS warns that EM could suffer once the Fed reverses course, given the USD9.6 trillion in offshore borrowings racked up worldwide on the back of zero interest-rate policy (ZIRP) and quantitative easing in the US. They caution that cheap money encourages debt accumulation and harmful risk-taking while much-needed investment in the real economy takes a backseat. The lack of comprehensive structural reform has meant that many EM central banks have become too dependent on ultra-accommodative monetary policy and as a result are vulnerable to the effects of a surging dollar and capital outflows in an environment where the US is expected to commence interest rate normalisation.
Growth fundamentals in EM remain weak. A tepid global trade cycle has exacerbated growth weakness as low productivity, anaemic loan growth and waning business sentiment have led to faltering domestic demand. Furthermore, currency weakness across the EM composite has only partly helped to alleviate the wide gap between EM and DM unit labour costs which has stalled gains in competitiveness. Although Deutsche Bank research shows that commodity exports as a share of total global exports have declined only marginally from c.35% in 2011 to 32% in 2014, the recent slump in the commodity cycle (triggered by a strong dollar and subdued global demand) poses further headwinds.
However, trade exposures to China for select EMs have increased. HSBC calculates that Latin America’s (LatAm) growth exposure to China has increased from 6.5% in 2007 to 11% more recently, while that of Europe, the Middle East and Africa (EMEA) has increased from 3.5% to 6.8% over the corresponding period. UBS shows that it has been no coincidence that growth momentum in countries with a larger exposure to China (e.g. Korea at 25%, Taiwan at 24% and Brazil at 18%) has slowed, while growth remained intact for those with a bigger exposure to developed markets (e.g. Mexico at 85%, Hungary at 62% and Poland at 59%).
Nevertheless, we see Chinese growth fears as being overdone. Admittedly, the Li Keqiang index (measuring highfrequency economic data) points to a sharper deterioration in year-on-year growth than official GDP numbers, but when key economic indicators (including exports, imports, industrial production and electricity consumption) are viewed on a sequential three-month basis, a stronger growth picture emerges. Moreover, Deutsche Bank’s measure of the credit
impulse (change in new credit issued relative to GDP) points to a promising rise in money supply.
There have been strong performances from the servicesrelated growth sectors in line with Chinese officials’ goal of redirecting the economy away from the more traditional drivers of growth (including manufacturing and exports) to a more consumption-driven economy. Nominal growth in the tertiary (services) sector of the economy accounted for the largest share of GDP growth in 2Q15 (see chart 2), increasing by a healthy 12.1% y/y in 2Q15 relative to a paltry growth print of 1.6% y/y in the secondary sector (including manufacturing and construction).
Chart 2: China’s nominal GDP stack-up (% y/y)
Source: NBS, Momentum Investments, data up to 2Q15
This economic transition is likely to see China’s growth rate falling to more sustainable levels from the 10.5% average experienced between 2000 and the GFC. We expect additional monetary stimulus and accelerated infrastructure spend to support growth of c.6.5% between this year and next.
Monetary policy facing a balancing act in SA
Global macro weakness and falling commodity prices paint a bleak picture for the South African economic outlook. External strains only exacerbate the fragile domestic demand picture revealed in the South African Reserve Bank’s (SARB) September Quarterly Bulletin. Disappointing demand conditions and electricity load-shedding saw a sharp contraction in inventories in 2Q15, while lacklustre expenditure by households and a further deceleration in capital outlays by private enterprises led to a loss in economic momentum.
Corporate tax revenues have unsurprisingly come under pressure in line with faltering growth and muted commodity prices. In contrast, personal income taxes and VAT revenues have held up well, actually surpassing government’s fiscal targets on a year-to-date basis. Nevertheless, subdued economic growth in the outer years of the expenditure framework could obscure government’s fiscal consolidation efforts over the medium term. This makes adhering to the overall expenditure ceiling (by potentially cutting expenditure elsewhere to offset a worse c.10% outcome on the budgeted for 7.7% public sector wage deal) even more important. Given the recommendations of the Davis Tax Committee, we are not expecting any announcements on major changes to the tax system in the upcoming budget, but instead expect further compliance improvements to close tax loopholes or marginal adjustments to the upper tax brackets.
As such, we do not see SA’s investment-grade rating as being under immediate threat. Junk status concerns followed on the back of rating agency Standard and Poor’s (S&P) rating downgrade of Brazil to junk status as a second revision to budget deficit targets within a short space of time highlighted the Brazilian government’s lack of commitment to its fiscal consolidation path. S&P cited ongoing challenges on the political (including corruption investigations) and economic (a longer and deeper downturn expected) front as key reasons prompting a downgrade, as the outlook for fiscal metrics had deteriorated sharply. Brazil’s government deficit is likely to average c.8% over 2015-2016, while the government debt ratio
ratcheted higher from c.54% at the start of 2014 to 64% more recently.
In comparison, Treasury’s projections in February this year predicted SA’s net debt, provisions and contingent liabilities to decline to 57.3% of GDP by FY2017/18 from 58.1% in FY2015/16. Nonetheless, if SA is unable to tackle the funding struggles of the state-owned companies through the sale of state assets, further efforts to support these enterprises could add to the fiscal burden in the medium term. Furthermore, political rhetoric around the largely unaffordable nuclear power deal poses a fiscal threat down the line.
Even though we do not expect a downgrade to junk status by either Fitch or S&P rating agency in December this year, the rand remains under pressure from a number of externallydriven and domestic factors. With roughly 30% of SA’s exports destined for Asia, a potentially negative terms-of-trade shock, borne out by a steeper decline in SA’s key export prices relative to our import prices, could keep the currency under pressure in the near term. Although SA’s relatively lower political risk environment has buffered the levels of foreign portfolio inflows since the GFC, Chinese growth concerns and imminent US Fed interest rate hikes have led to a further c.8% weakening in the rand on a trade-weighted basis since the last SARB Monetary Policy Committee (MPC) meeting.
Although a still-negative, but closing, output gap has depressed demand-pull inflation pressures and has limited the pass-through of a weaker exchange rate, above-inflation wage settlements, steep administered price increases and higher rand food prices point to higher rates of headline inflation in upcoming months, leaving the average expected rate in 2016 close to 6%.
Moreover, longer-dated inflation expectations, of businesses and trade unions in particular, remain stubbornly high at the top end of the inflation target band, posing a threat to secondround inflation pressures.
A fragile growth backdrop complicates monetary-policy decision making for the SARB. Nevertheless, an expected widening in SA’s current account deficit in the remainder of the year, sticky inflation expectations and an anticipated rise in inflation argues for another interest rate hike of 25 basis points before year end and a further 50 basis points over the course of next year. This would take the repo rate to a level of 6.75% and real rates into mildly positive territory by the end of 2016.
