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Stumbling, but still standing

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

Global equity markets are up strongly in the first seven months of the year, but encountered three stumbling blocks last week. The first is that the latest data show that the world economy outside the US is sputtering, particularly the world’s factories. The JPMorgan Manufacturing Purchasing Managers’ Index fell further in July to 49.3 index points, below the neutral level of 50. Meanwhile, the International Monetary Fund (IMF) trimmed its outlook for 2019 global growth to 3.2%, the slowest pace of expansion since 2009. It listed a predictable set of factors weighing on the global outlook, including the risk of a no-deal Brexit, sluggish business investment and a weak vehicle market, and of course the uncertainty around US-China trade talks.

Tariff Man strikes again
Secondly, these trade talks don’t seem to be going well, judging by US President Trump’s announcement that he intends slapping 10% tariffs on imports from China currently not taxed. This is about $300 billion a year worth of mostly consumer goods, whereas Trump’s previous tariffs mainly impacted goods used by business as inputs. In other words, if implemented, it would hit the pockets of US consumers (and voters). The immediate market reaction was negative, as can be expected.

Mid-cycle adjustment
The third stumbling block came from the most eagerly anticipated interest rate announcement in years. The US Federal Reserve cut its policy rate by 0.25%, the 14th central bank to cut in July, but this reduction was more than priced in. The market was hoping for a stronger indication that future hikes would be forthcoming. Instead, Fed Chair Jerome Powell characterised the rate cut as a “mid-cycle adjustment”, indicating that rates could fall further if the economic data warranted it, but that this was not a given.

Chart 1: Major central bank policy interest rates

Source: Refinitiv Datastream

After all, the US economy is still in good shape, outside of the manufacturing sector. Though growth slowed in the second quarter, to 2.1% from 3.1% in the first quarter, it was stronger than expected. In particular, it reflects healthy levels of consumer spending. It also showed the biggest contribution from government spending in years, as fiscal spending contributed. In a separate development, an agreement between the Democrat-controlled House of Representatives and the White House ensures that the debt ceiling will be raised, with room for $320 billion additional government spending over two years. The surge in US government borrowing has been comfortably absorbed by a bond market starved for safe-assets with a yield.

Government borrowing usually declines late in the economic cycle as a strong economy boosts tax revenues, so we are in unfamiliar territory. If a recession does hit with an already wide budget deficit, it could limit the ability of fiscal policy to respond. But that is a question for another day. If the US economy is seemingly doing well, why the rate cut? Firstly, inflation remains low. Personal consumption inflation on items other than fuel and food rose 1.6% in the year to June, while the Fed targets 2%. The Fed is concerned about the possibility that consumers and businesses start believing that inflation will always be below 2%, and start acting accordingly. It wants inflation expectations to remain anchored at 2%. Secondly, a soft global economy could spill over to US shores, and a rate cut aims to pre-empt this. Though it would not spell it out directly, the implication in the Fed’s statement was that the uncertainty created by Trump’s trade wars was a big reason behind its rate reduction. By upping the ante on China, Trump may be pushing the Fed to cut more, something he has demanded they do.

Dollar still strong
Complicating the outlook for the Fed is that the dollar strengthened to a two-year high. With other central banks also cutting (or set to cut), the convergence in rates between the US and its main trading partners seems less likely. A strong dollar would put further downward pressure on inflation and hurt US exporters and import-competing businesses. Generally speaking, the stronger dollar offsets some of the easing of financial conditions brought about by the decline in market-linked interest rates (the 10-year Treasury yield fell below 1.9% last week, the lowest level since Trump’s election in November 2016). A strong dollar also weighs on the foreign earnings of US multinationals. With more than half the S&P 500 companies having reported second quarter results, year-on-year earnings is marginally positive. This is despite the very high base set in 2018 by corporate tax cuts and strong economic growth. An analysis by Refinitiv shows that companies that earn most of their revenues in the US posted a solid 6% earnings growth in the second quarter, while companies that mostly earn revenues outside the US posted a 9% earnings decline.

Chart 2: Trade-weighted US dollar index

Source: Refinitiv Datastream

With the US market still up 18% year-to-date (and 6% over one year), despite last week’s wobbles, there is clearly an expectation that earnings growth will accelerate in the second half of the year. Simply put, central bank easing will have to offset the negative impact of tariff uncertainty.

Local setbacks
The local equity market also suffered setbacks last week, but it never had the flying start to the year global markets did. The FTSE/JSE All Share was negative in July, declining by 2.4%. The 2019 return of 8.6% is still decent, though it hasn’t made up for 2018’s losses and the index remains below all-time highs. In a smaller and concentrated market like South Africa’s, stock-specific issues can move the benchmark. The list of companies that have reported poor capital allocation decisions, particularly offshore acquisitions, continues to grow. But macroeconomic conditions and policy uncertainty also play a role for the slightly less than half of the local market exposed to the domestic economy. The IMF cut South Africa’s growth outlook to only 0.7% this year and 1.1% next year.

Chart 3: SA and Brazilian total return equity indices

Source: Refinitiv Datastream

The most immediate domestic problem remains Eskom. Eskom hurts the economy in four principal ways. The inability to guarantee electricity supply hurts existing producers and discourages new investments. The tripling of electricity tariffs in real terms over the past decade has squeezed consumers and businesses alike, particularly energy-intensive mines and factories. The uncertainty this creates weighs on financial markets, raising borrowing costs. Finally, Eskom is absorbing funds that could’ve been used elsewhere. Government borrowing in the current fiscal year could rise to almost R300 billion to accommodate the Eskom bailout and disappointing tax revenues. Unlike the US, borrowing costs are higher than nominal economic growth, indicating that the current fiscal situation is not sustainable.

Usually increased government borrowing (a larger budget deficit) is considered positive for short-term economic growth. If the borrowed funds are invested in infrastructure, it is good for longer-term growth too. Unfortunately, rather than doing something ‘useful’ with the cash, it is being used to fund Eskom’s interest payments. Eskom generates most of its electricity by burning coal, but in recent times it seems to burn through cash too. It announced a record R21 billion loss for the year to end March, largely due to a total debt burden (interest and capital repayment) of R69 billion. Its operating costs also jumped, with the wage bill rising 13%, almost three times the inflation rate. (To be completely fair to Eskom, it in turn is owed a staggering R40 billion by municipalities.) Consumers are increasingly looking for cheaper alternative sources of electricity and reducing use as far as possible. Eskom’s sales therefore declined over the past year. Hiking tariffs to compensate for the resulting loss in revenue will only chase more customers, in what has become known as the “utility death spiral” in other countries. It cannot grow its way out of its problems. The appointment of a Chief Restructuring Officer is an important milestone, but ultimately, the biggest stumbling blocks to restructuring are political and not technical.

Ratings not the be-all and end-all
Since the government guarantees most of Eskom’s debt, it is ultimately on the hook. Further credit ratings downgrades are a possibility, and bonds, rate-sensitive shares and the rand have come under pressure in the past two weeks (though the stronger dollar played a bigger role in the rand’s weakness). How much do credit ratings really matter though? Here we might look at the recent case of Brazil. Long bond yields halved from 16% in early 2016 as inflation fell from 10% to 3%, and the central bank cut its policy rate from 14% to 6% over this period, including by 0.5% last week. Meanwhile, Brazilian equities doubled. All this despite tepid economic growth, government debt growing by 75% and its S&P credit rating being cut two notches below junk status. Partly this reflects investor excitement over reforms to the unsustainable public pension system. However, the positive impact of these changes will be felt over time and not so much in the short term. Still, it shows that markets will latch on to a credible reform story, more so now that interest rates globally are falling and the desperate search for yield is on. Unfortunately, South Africa doesn’t have such a credible reform story at the moment. This can still change.

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