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Inversion, submersion and dispersion

20 August 2019 Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist) from Old Mutual Wealth

Global equity markets enjoyed a temporary bounce last week when the US government said it would postpone the imposition of tariffs on some Chinese goods, while some items would not be taxed at all. President Trump initially planned to impose 10% tariffs on $300 billion Chinese imports at the start of next month. It does show that the Trump administration is worried about the impact of tariffs on the US economy, and wants to avoid prices on consumer items jumping ahead of the Christmas shopping season. However, this was soon overtaken by renewed concerns over the health of the global economy.

Submersion
New data showed that Germany’s economy contracted in the second quarter, which is no surprise since it is heavily dependent on exports, particularly in the struggling automotive industry. It is also exposed to China, where July data showed the economy slowing more than expected, and to the UK, plagued with Brexit uncertainty. The entire German yield curve is now submerged below zero, screaming for the tight-fisted German government to borrow more and spend more. But the country’s leaders remain committed to the schwarze Null (black zero) of a balanced budget. In ordinary times, that might be commendable, but these are clearly not such times.

Chart 1: 30-year government bond yields, local currency %

Source: Refinitiv Datastream

Inversion aversion
Global weakness saw a rush into the perceived safety of bonds, with the US 30-year bond yields falling below 2% for the first time. In other words, the market expects interest rates to be below 2% for the next three decades, an extreme outcome. More ominously, 10-year bond yields dipped below 2-year yields for the first time since 2007. This spooked the equity market as the so-called inversion of the yield curve has preceded past recessions. Essentially, it means that the market expects the future to be worse than the present. It is important to note that the inverted yield curve does not cause a recession (unless it scares ordinary Americans to stay at home and stop shopping). Rather, it reflects the bond market’s expectations of near-term growth, inflation and interest rates versus longer-term expectations. The near-term expectations are anchored on the policy stance of the Federal Reserve (the Fed), so that the market is effectively saying the Fed’s rates are too high now and it will be forced to cut rates.

Chart 2: The spread between 10-year and 2-year US government bond yields %

Source: Refinitiv Datastream

This creates a dilemma: on the one hand, you shouldn’t ignore the bond market, and the most dangerous words in finance are said to be “this time is different”. On the other hand, this time might really be different. No other tried-and-tested recession indicator is flashing red, and the collapse in bond yields in Europe and elsewhere must surely play a role in dragging US yields down. These, after all, are now the highest yields in the developed world. Canada, Australia, Britain and even politically-unstable and highly indebted Italy have lower yields than the US. This also reflects the relative strength of the US economy. All the latest reports on the US economy show healthy levels of consumer spending, supported by a strong job market, low inflation and low interest rates. The US manufacturing sector, along with those in other major countries, is struggling. Despite President Trump’s efforts, the trade wars seem to have hurt rather than helped US manufacturers in total (though some will have benefited). But this is a small part of the services-driven US economy. The trade wars are also causing pain in other countries, notably China, where industrial production growth in June was the slowest in decades (but still strongly positive).

Cutting in droves
Central banks are of course already cutting rates in droves, with Mexico the latest major economy to do so. The US Fed is likely to follow suit at its September meeting. The market will want to see not only a cut from the Fed, but the guidance that future cuts would also happen. These rate cuts will not do much to stimulate new borrowing since global debt levels are already so high, but will ease the pressure on existing borrowers. Importantly, central banks will act to prevent a repeat of 2008 when market stress impacted the real economy as credit channels seized up. How will the SA Reserve Bank respond? It has already cut rates once, but this was just reversing November’s hike. The recent sell-off in the rand might preclude it from cutting at its next meeting, but oil prices have also pulled back. The Reserve Bank will also be viewing the deteriorating fiscal position with some alarm. However, in the current context, the widening budget deficit is not inflationary, since it is bailing out Eskom, not stimulating domestic spending. Ultimately, the Reserve Bank is likely to follow other central banks and lower rates.

Dispersion
This is because, in the global dispersion of real interest rates, South Africa is now close to the one extreme, with Germany at the other. As global fixed income yields plummet, South Africa has gone in the other direction. Foreign investors have pulled money out of the local bond market, worried that government borrowing will rise dramatically to fund Eskom. The tabling of a draft National Health Insurance (NHI) bill has not helped sentiment either. While it has noble objectives, it would entail potentially hundreds of billions in additional annual outlays upon planned final implementation in 2026. (The estimated costs and funding mechanism have not yet been announced.) With markets already questioning South Africa’s fiscal management, the timing was not great. Realistically though, it is hard to see how such a complex restructuring of such a large and important sector can be achieved in seven years, and a more piecemeal approach seems likely.

But a lot of the pessimism is surely overdone. While government debt is rising due to Eskom and weak tax revenue growth, the government is far from bankrupt. The increased talk of South Africa turning to the International Monetary Fund (IMF) for assistance is also misplaced. The IMF itself sees no reason why we can’t sort out our own problems without its help. It has noted that the asset side of the government’s balance sheet is larger than the liability side, but the assets need to be ‘sweated’, or sold, to deliver a decent social or economic return. The IMF helps countries that run out of dollars to repay debt or fund imports, usually when capital flows dry up. South Africa’s government debt is mostly rand-denominated and there is no sign that it is struggling to fund itself in the local bond market. The flexible exchange rate takes care of the rest. South Africa is not Argentina, dependent on borrowing abroad in dollars.

Argentina turned to the IMF last year (for the biggest bailout on record) precisely because the lack of a domestic bond market means the government borrows in dollars. However, last week its financial markets suffered a sharp collapse – currency, equities and bonds slumped between 30% and 40% overnight – after the reformist President Macri lost a key indicative vote ahead of October’s presidential elections. Much like President Ramaphosa, Macri tried to clean up a huge mess left by his predecessor. However, the medicine he prescribed was too bitter for the people of Argentina, but not bitter enough from the point of view of the markets, who have been fleeing Argentinian assets for the past 18 months. Now it appears Macri is on his way out, to be replaced by a populist who investors fear will make things worse, while promising to make things better.

The JSE is not the economy
It is easy to connect the dots between all this local political and economic uncertainty and the continued poor performance of the JSE, but this connection is overstated. In fact, the JSE has been hit by a perfect storm of events, and virtually everything that could go wrong seems to have done so in the past three years. The JSE has also performed in line with other non-US stock markets over the past three years and longer, a period where only US equities have performed really well (see chart 3). There is no question that the weak economy has hit domestically orientated shares, and the NHI bill is another example of policy uncertainty weighing on share prices (this time of medical insurers). But more than half of the earnings of JSE-listed companies is generated outside South Africa. The global presence of local companies has also increased over the past few years, with Reserve Bank data showing that domestic companies invested almost R500 billion abroad over the past seven years, but without much to show for it. There are several examples of poor offshore acquisitions, with Woolworths, Truworths and Famous Brands standing out.

Crucially, JSE exposure to the high-flying US market is low, while exposure to the UK is relatively high. Overall, the global exposure of the JSE is concentrated, and subject to company-specific issues. For instance, Sasol’s problems caused another sharp pull-back in its share price last week. Last year it was the 40% decline in British American Tobacco and 20% decline in Richemont. All three are big components of the local benchmark. This year, only Naspers and mining companies have performed well, the latter can still largely be viewed as a recovery from the pre-2016 rout in commodity prices, with the weak rand also helping.

Chart 3: The JSE and other major equity indices over the past decade in US dollars

Source: Refinitiv

Usually, an equity market sell-off is accompanied by a decline in interest rates, so that shares become more attractive and fixed income less. This has happened globally, but not locally. In fact, high rates are just one of the reasons why local equities have struggled. Both short and long-term fixed income yields stand out like a sore thumb in the international context and offer very attractive real returns. However, the risk remains that in viewing the poor performance of the JSE as a South Africa-specific story, investors become so mired in pessimism that they assume it can never recover. Domestic shares already price in a very gloomy medium-term outlook for the South African economy and can positively surprise on any evidence of a slightly improved outlook and a rebound on global equity markets.

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