Key investment themes over the second quarter

Luigi Marinus, Portfolio Manager at PPS Investments.

After the marked increase in volatility worldwide in the first quarter of the year, volatility eased in the second quarter as global markets slowly edged higher. The biggest talking point globally has been the implications of a global trade war, especially from a South African perspective and emerging market economies.

What pressure is the US-China trade war placing on emerging markets, such as South Africa?

The most topical global economic question, which is probably also the hardest to answer is the expected effects of the trade war, primarily between the US and China.

Trade wars of this nature has in recent decades made way for the advantages of globalisation. The factors of production could be utilised wherever in the world it was most efficient without excessive associated costs. This has resulted in a larger pie of profitability that benefits many countries across the world, including emerging market economies.

US President Donald Trump believes that the US receives a disproportionately small slice of the pie and that by increasing tariffs the US slice would increase, even if the pie itself became smaller. Regardless of whether this is sensible or not the cost of production in emerging economies is likely to increase making them less competitive. This in turn may have an increasing effect on price levels and eventually result in increasing inflation worldwide.

Will the oil (and petrol price) continue to rise?

The last time the price of oil was more expensive than US$100 per barrel was in 2014, and the low post that nearly reached US$25 at the beginning of 2016. Since that point the oil price has gradually increased and went back above US$75 in 2018.

Oil-producing countries have been more disciplined in their production, resulting in a cap in supply and a gradual increase in the oil price. In addition, fracking production has declined as the low oil price resulted in non-profitable operations. There is a school of thought that suggests that as the price of oil reaches a certain level fracking would become profitable again and the increased supply would lead to a ceiling for the oil price.

Even with the increase in electric cars and green energy, oil remains the largest source of energy worldwide and any constraints to supply or demand surprises are likely to have an impact on the oil price.

How could this likely impact inflation?

The price of oil remains an important consideration for many economies, including South Africa, as the effect on the price of petrol and in turn on inflation is notable.

South Africa has, however, been experiencing a period of benign inflation with the release for May showing an increase of 4.4% year-on-year. The action on the rand compared to the US dollar has played an important role on the effect of the oil price on South African inflation. The exchange peaked at about the same time that the oil priced reached a low (early 2016). This has meant that the increasing oil price in US dollars since 2016 has, to some extent, been offset by the strengthening rand over the same period.

The post-Ramaphosa euphoria period has again seen a weakening of the rand since the lows at the end of the first quarter. A continuation of this trend will have a negative effect on inflation.

What are the interest rate expectations?

Interest rate expectations have certainly changed more recently. Technically, the South African Reserve Bank (SARB) is still in a cutting cycle and with inflation as low and stable as it has been, the change in expectation may be viewed as surprising. Global markets and particularly the US have continued to increase short-term rates. The additional expectation is for this to effect two interest rate hikes of 25 basis points each in the second half of the year.

The increase in global interest rates, together with the recently depreciating rand and an understanding that the demand for bonds has followed opportunities where yields have become more competitive, does provide a thesis for increasing rates in South Africa.

The primary mandate of the SARB is, however, to keep inflation within the target band, so the central bank may find it difficult to increase rates if inflation remains well below the top end of the band. All being said, though, SA inflation is expected to remain in the 3%-6% band for the rest of the year.

Given the latest disappointing GDP figures, what does South Africa’s growth trajectory look like?

It was largely expected that the most recent GDP growth print would be negative. The size of the decline was, however, somewhat of a surprise. The South African economy declined by 2.2% annualised, compared to the previous quarter.

Since the release of this figure there have been some adjustments to GDP growth expectations. For the most part these expectations have remained between 1% and 2% for 2018. Arguably, the most important of these expectations are from The World Bank which adjusted its forecast upward from 1.1% to 1.4% and the International Monetary Fund (IMF) that raised its forecast from 0.9% to 1.5%.