Commodities and consumers hold the key

Dave Mohr, Chief Investment Strategist at Old Mutual Multi-Managers.

Izak Odendaal, Investment Strategist at Old Mutual Multi-Managers.

Confidence in the South African economy suffered fresh blows over the past two weeks, including news that we are in a technical recession. On a policy and political front, the new mining charter and public protector’s recommendation that the constitution’s Reserve Bank clause be changed, caused a brief sell-off in the rand. If implemented in current form, both the charter and the public protector’s recommendation would have negative consequences. However, this is unlikely since both the Reserve Bank and the Chamber of Mines have indicated that they are heading to court.

Global factors still dominate

Despite these blows, the rand still closed last week below R 13/$ and the global environment remains favourable to South Africa. Low interest rates across the developed world entail a demand for high-yielding assets in emerging markets. Just last week, politically unstable, deeply junk-rated, inflation-plagued Argentina sold $2.75 billion of a 100-year bond. This is a country that has defaulted on its debt five times in the past 100 years, most recently in 2014. This global environment presents a window of opportunity for South Africa to implement the necessary reforms rather than scoring policy own goals. However, history tells us that in most cases countries only embark on serious reforms when faced with a severe actual or perceived crisis.

Political and policy certainty would be very helpful, but seems unlikely until the end of the year (at the earliest) and probably beyond. Business confidence is low and South African companies have ramped up acquisitions abroad in search of diversification and better growth. While private fixed investment in the local economy improved somewhat over the past two quarters, it remains subdued. Since fiscal consolidation is still ongoing, government spending is also not going to support growth. In fact, subpar growth increases pressure to raise tax rates. The key to South Africa’s recovery prospects are therefore external (commodity prices) and consumer spending (which accounts for 60% of GDP).

Commodity prices plunged across a broad front between 2011 and 2015 as China’s economic growth rate slowed and the US dollar strengthened. This had a massive impact on the local economy, not just on the mining sector but also manufacturing, construction, transport employment and state finances. Last year saw a decent rally in South Africa’s main commodities (especially iron ore and coal), and economic prospects increased accordingly. Commodity prices are also still low in real terms compared to historic levels. However, the past two months have unfortunately seen fresh declines in coal and iron ore, while platinum and gold (the other two main exports) have been treading water. While the firming global growth should provide decent support for commodity prices, further volatility could weigh on the domestic economy.

Thankfully from a South African point of view, the oil price is also down around 20% since the start of the year, which is useful since we are a net importer. Unlike with some other commodities, it is pretty clear what is driving the declines: there is a glut of oil as American shale production, more efficient and cost-effective than ever, has rebounded, overwhelming OPEC’s output cuts. In 2014 and 2015, the sharp decline in the oil price probably saved South Africa from recession. It reduced our import bill, lowered input costs for businesses and inflation for consumers and allowed a boost in tax revenues (through the fuel levy) without leaving motorists worse off. Perhaps such luck could befall us again.

Unlike in 2014 and 2015, the decline in the oil price has not resulted in a sell-off on global equity markets.

Breathing room for consumers

In terms of the outlook for consumers, there is reason for cautious optimism due to lower inflation and the potential for modest interest rate cuts. Inflation in May was 5.4% year-on-year. Food inflation, the main recent driver of high inflation, was 6.9% compared to a peak of 12% in December. Core inflation – excluding volatile food and fuel prices – was unchanged at 4.8%, close to the mid-point of the Reserve Bank’s target range. High inflation in the past two quarters was one of the key contributors to negative real consumption spending and therefore negative GDP prints. Receding inflation implies scope for increased real spending. Some – but not all - of this gain is likely to be taken away by SARS next year as the Finance Minister faces another tax revenue shortfall leading up to his first Medium Term Budget Policy Statement.

Household incomes are growing faster than debt (which is barely growing at all) and therefore households are de-gearing. Expressed as a percentage of household disposable (after-tax) income, household debt declined from a peak of 88% in 2008 to 73% in the first quarter. Put differently, the ratio is lower than a decade ago. The cost of servicing this debt (i.e. the interest burden) has stabilised at around 9.5% of income in the first quarter. It climbed by a full percentage point from 2014, eroding household spending power. In 2008 this ratio hit 14%, contributing to a deep consumer recession.

With consumer confidence as low as it is, a rapid increase in borrowing is very unlikely. With households deleveraging, stable or lower interest rates over the next year imply a decline in this ratio, freeing up some room to spend, presuming income growth stabilises.

Scope for interest rate cuts

The Reserve Bank’s independence is a key issue for ratings agencies and bond investors who are always at risk that inflation might eat away the value of fixed coupon payments. Since the Reserve Bank implemented inflation targeting in 2000, inflation averaged 5.8% and the prime rate was 11%, down from 12% and 17% respectively between 1980 and 2000. Lower rates and lower inflation benefit everyone, not just the wealthy.

That doesn’t mean that the SARB hasn’t made mistakes in monetary policy setting from time to time, with rates either too high or too low for prevailing economic conditions. But the SARB cannot be blamed for South Africa’s poor economic performance. Interest rate setting addresses cyclical conditions in the economy, not the economy’s underlying structure. Current cyclical conditions are calling for lower rates. As measured inflation and most main inflation drivers are falling and the economic recovery increasingly at risk, the case for rate cuts is stronger.

South Africa’s external vulnerability has also eased. New data from the Reserve Bank showed that the annualised current account deficit of R 92 billion (2.1% of GDP) in the first quarter was marginally higher that in the fourth quarter of 2016, but more than half of the 2014 level. A smaller current account deficit – which broadly measures our current liabilities with the rest of the world – reduces a key source of vulnerability for the rand. South Africa’s large ‘twin deficit’ (the combined fiscal and current account deficit) led to the country being considered as one of the ‘fragile five’ emerging markets (along with Turkey, Brazil, India and Indonesia). However, this deficit has declined from 10% in 2014 to 6%, removing one of the Reserve Bank’s reasons for maintaining relatively high rates.

Chart 1: Key commodity prices over five years, US dollars, rebased to 100

Source: Datastream

Chart 2: South African consumer inflation, %

Source: StatsSA