Art of the (phase one) deal

Suddenly, it looks like there is progress on two of the big geopolitical risks of the moment. Risk assets rallied in response even as global growth concerns continue to mount and reported earnings growth remains muted. Following a meeting between the prime ministers of the UK and Ireland, an orderly Brexit seems possible after all. More importantly, there has been progress on resolving the trade dispute between the world’s two largest economies, the US and China.

Representatives from the two countries met last week in Washington, D.C. and agreed to halt any further tariff increases in what US President Trump called a “substantial phase one deal”. China will also buy more US agricultural goods, open key financial markets further and it has agreed to not devalue its currency. There has been no agreement on the structural changes that the US wants to see China make, mainly on state support and subsidies for Chinese firms. These will be addressed in future negotiations, but are likely to linger as a source of tension. Nonetheless, the trade truce is good news. US tariffs on a range of Chinese imports were set to increase substantially on Tuesday, and again in December on the remaining goods not yet taxed.

Though the two sides have struggled to find one another in recent months, the incentive to do so has increased. The trade war is clearly starting to hurt both economies. In the case of the US, manufacturing is close to contracting, which is ironic since it is this sector that President Trump wanted to support with tariffs in the first instance. (The much larger US service sector is still fine.)

Chart 1: Global equities in 2019, US dollars

Source: Refinitiv Datastream

Markets respond rapidly to any changes in the environment, immediately pricing in the latest good or bad news. On the ground, businesses and consumers take longer to change their views. The latest trade truce might not do anything to change the decisions of a corporate CEO who has to plan for the next few years, if he or she worries that President Trump can still change his mind in six months. In contrast, six months is a lifetime for most market participants (unfortunately). Ditto with the Brexit breakthrough. In other words, the damage done to business confidence, and the willingness of firms and consumers to make long-term commitments, will take longer to heal. At any rate, central banks are not taking any chances. They are still cutting rates and taking steps to support their respective economies. So far this month, central banks in India, Australia, Uganda and Iceland have reduced policy interest rates.

Fixing the financial plumbing
Significantly, the US Federal Reserve (the Fed) announced it would start buying bonds again. It will buy $60 billion a month in short-dated bonds for the next three quarters with the aim of increasing bank reserves (cash banks don’t lend to clients) to ensure smooth functioning of money markets (and by extension, the implementation of monetary policy through changes in the fed funds rate). Fed Chair Jerome Powell was at pains to point out that this was not the start of a new round of crisis-fighting quantitative easing (QE). Rather it should be seen as a technical adjustment to prevent a key element of the US (and by implication, global) financial plumbing from gumming up. Already, the Fed had to provide liquidity into the repo market (where banks borrow from one another), as can be seen by the unexpected uptick in the size of its balance sheet on chart 2.

Even if the intention is very different, it does look a lot like QE. Therefore, it will be an interesting experiment in terms of how the market reacts. Many commentators have argued that QE as a form of “money printing” was responsible for much of the equity gains since 2008 as it created liquidity that flooded markets. In reality, the QE boost probably was mostly psychological as the “money printing” was not money as we know it, but bank reserves. A large portion of these reserves also remained in accounts at the Fed, instead of being put to work in financial markets. Therefore, past QE-related rallies were mostly investors responding to the perception that the Fed and other central banks had their backs.

Chart 2: Federal Reserve assets

Source: Refinitiv Datastream

Either way, the Fed is still expected to cut its policy rate later this month, with the latest inflation data giving it the green light to do so. Consumer inflation in the US dipped to 1.7% year-on-year. Cuts are already priced in, and since a large percentage of loans in the US economy is priced off market rates, the stimulatory impact to the real economy is fairly immediate. Not that one would expect a surge in new borrowing, given high global debt levels. Instead, borrowers have the opportunity to refinance loans at lower rates and enjoy the savings.

In Europe, inflation is also well below the European Central Bank’s 2% target. In fact, it is around half of where it is supposed to be. Frustratingly, the various market-based expectations of future inflation (such as the difference between nominal and inflation-linked bond yields, or in the pricing of inflation swaps) have declined since the ECB launched its latest round of QE and rate cuts. The market doesn’t believe these steps will be enough.

Implications of low rates
Global interest rates won’t necessarily stay at these levels for ever, and someday Japan and Europe might even see positive rates again. But it is very difficult to see a return to pre-2008 levels within the next few years. After all, even when the world was still celebrating ‘synchronised global growth’ in 2017, European and Japanese interest rates were negative and US rates had barely reached 2%. It would take substantially stronger growth and higher inflation for rates to rise on a sustained basis.

This is forcing investors to search for yield in unexpected corners. Even Greece – Europe’s most indebted economy – issued a negatively-yielding bond for the first time last week (albeit of short duration). At the height of the so-called PIIGS crisis when investors abandoned the bonds of Portugal, Italy, Ireland, Greece and Spain in 2012, Greek 10-year yields spiked to 37%. As recently as February 2016, the Greek government was still paying more than South Africa to borrow. Since then, Greek yields have collapsed (while South African yields moved sideways) and this is despite Greek bonds not being eligible for the ECB to buy as part of its upside-down QE programme (upside-down because it buys more of the safer bonds instead of buying the bonds of the weaker countries who would benefit most).

Chart: 10-year government bond yields in local currency

Source: Refinitiv Datastream

In considering all of this, there are three broad thoughts that come to mind. Firstly, even with all the risks and uncertainties, global equities are surely a better bet than bonds unless you expect the world to fall apart completely, i.e. a repeat of 2008. In most major markets, dividend yields now exceed long bond yields, implying a higher return from equities even if there is no capital gain. (Of course, it is partly the fear of capital loss that has pushed bond yields so low in the first instance.)

Secondly, the longer-term implications for how capitalism functions if there is no return on ‘safe’ assets are unknown. Do such low rates help or hinder? Does it force a more entrepreneurial (risk-taking) mind-set? Or does it do the opposite and induce a sort of paralysis where no one wants to take risk because they see low interest rates as a sign that things are deeply wrong? Or both? Only time will tell. The country that is the farthest down this path is Japan, where investors and business people have had to live with near-zero interest rates and falling prices for two decades. Other countries in Europe and Asia will in time have Japan’s unfavourable demographic profile, with an ageing and shrinking population, though in the case of Japan it is worsened by the lack of immigration.

Standing out
Thirdly, against this global backdrop, South African interest rates still stand out like a rugby lock among scrumhalves. The South African government borrows at 9%, you and I borrow at a rate linked to prime of 10%.

High interest rates in South Africa are largely linked to fiscal concerns. The market is worried that government debt is rising too quickly, putting pressure on credit ratings, with a possible Moody’s downgrade on 1 November. The longer-term picture is a worry, if persistently weak economic growth results in rising debt levels, which combined with high interest rates, is unsustainable. Ironically therefore, high interest rates reflect the fear that interest rates will be too high! The example of Japan, with a debt ratio of four times that of South Africa, shows that high debt levels don’t matter much as long as rates remain low. The Reserve Bank is also worried about these issues, and keeping rates high in real terms as a form of insurance.

Positive noises
The latest data suggests that the economy is still facing headwinds. Last week’s mining and manufacturing output releases indicate that these volatile sectors are likely to drag on third quarter overall economic growth (after contributing in the second quarter). But there are also some positive noises about economic reforms from government and the ruling party, and President Ramaphosa in particular. Nothing too controversial (no privatisation and labour market deregulation) but simple steps that move us in the right direction and should raise our growth rate over time. The impact of these changes, such as making it easier for tourists and skilled immigrants to get visas, will be measured in years rather than months, but are positive nonetheless. For investors to get excited about South African assets, the way they’ve latched on to Brazilian bonds ahead of impending public sector pension reforms there, will require that these changes become official government policy, and not remain in the terrain of policy papers, advisory panels and conference agendas. The expectation is building that the Medium Term Budget will deliver something concrete in this regard, including measures to trim government spending.

Spending cuts unfortunately have a negative impact on the economy in the short term. However, this can be offset somewhat by lower interest rates. The more comfort the Reserve Bank has in the fiscal position, the more likely it is to join other central banks in cutting rates, providing relief to squeezed consumers. In the meantime, local investors, especially those living on their retirement capital, benefit from having some of the highest real interest rates in the world.