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Improving global economies no panacea for South Africa

05 November 2014 Dane Schrauwen, Foord Asset Management

Forecasting future economic conditions is fraught with difficulty, yet it is an exercise worth undertaking.

With US economic growth apparently gaining momentum, speculation has intensified regarding the timing and extent of US interest rate increases. Interest rate normalisation in the US has profound significance for the level of the rand and for the South African economy, interest rates and financial markets.

Over the next twelve to eighteen months, Foord expect one of three scenarios to manifest. The first scenario is our “base” case and the one that we believe most likely to eventuate. In this scenario, the US economy will continue its steady growth trajectory. Steady US growth will allow the US Federal Reserve to gradually raise rates from the current zero percent, starting in the middle of 2015. This slow pace of adjustment will allow currencies and financial markets to adjust in an orderly fashion. Stronger US economic growth will largely offset the negative impact of higher interest rates.

For South African investors, equities would be the preferred asset class in an environment of rising US interest rates. A moderately weaker rand and moderately higher SA interest rates will impair returns from bonds and listed property investments. However, South Africa’s economy is likely to continue facing a number of headwinds. Accordingly, international equities are likely to be the best performing asset class, eclipsing the SA equity market.

The second potential scenario, manifest in Europe at the moment, is one of global stagnation. Although anaemic global growth would inhibit economic activity in South Africa, there are some positives. The rand is likely to strengthen in such a scenario as foreign investors once more find favour in our higher yielding bonds and money markets. This will allow the South African Reserve Bank to maintain relatively low interest rates. This scenario favours investment in bonds and property over cash and equities, although returns are likely to be muted from all asset classes.

While the probability of this second scenario is relatively low, it is the scenario about which central bankers and policy makers in the developed world are most concerned. Later this month, the US Federal Reserve will cease injecting additional funds into the US economy. It has already guided the markets for interest rate increases. If the consequences of the Fed’s actions cause US economic growth to stall, this scenario would gain prominence.
The third possible scenario is one where the US economy enters a period of economic boom. Economic growth becomes self-reinforcing, fuelled by the surplus liquidity and low interest rates that the US Federal Reserve has been slow to remove. US interest rates will have to rise more swiftly than anticipated, which will be negative for all asset classes in the short term, barring cash. However, a boom will be good for corporate profits in the US and abroad and hence also equity prices, in the medium term.

Other central banks would also need to raise interest rates sooner and more aggressively than anticipated. The result would shock global financial markets and trigger a sell-off in all growth assets. Foreign investors in South Africa are likely to take flight from our markets as they seek higher and more certain investment returns in their home economies. This will result in a sharp depreciation in the rand, followed by a rapid increase in South African interest rates. This shock is likely to tip our economy into recession.

The Foord portfolio managers have taken these and other scenarios into account in constructing portfolios for investors that have a good probability of producing inflation beating returns whatever scenario manifests. Foreign equities remain our preferred asset class.

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