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ECONOMIC OUTLOOK

Maarten Ackerman

Chief Economist and Advisory Partner

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ARE WE THERE YET?

Much like children on a long car journey, markets are currently obsessed with asking: “Are we there yet?” This continuous fretting over the looming risk of a global recession has seen investors demonstrating a tendency to overreact to soft patches in the global economy, giving rise to periods of heightened volatility such as that witnessed in October and December 2018, and most recently in May this year. For instance, after United States (US) President Donald Trump tweeted on 5 May that he was going to increase tariffs on China from 10% to 25%, global equity markets immediately responded by pricing in a recession, shedding almost 6% in US dollar terms during the month. 

However, we are not “there” yet. The risk of a global recession is not off the table, but it will take a little longer to arrive given the recent U-turn by the world’s major central banks and key policymakers.

Market jitters aside, by offering economies the possibility of further stimulation to offset the slowdown in global growth, central banks have reduced the risk of an imminent global recession, extending the end of the current economic cycle for a while longer. According to Citadel’s recession scorecard, which analyses 10 global leading indicators, the likelihood of a recession occurring within the next 18 to 24 months remains below 50%.

In more good news for investors, we have also observed some green shoots in various leading global indicators, which seem to be bottoming out. These positive signs mean that investors can expect a slightly stronger second half to the year, especially given the promise of further stimulation which should boost growth over the next six months. 

It is also worth noting that despite a difficult global environment, company profitability has been supported by healthy global economic growth of slightly more than 3% in the first quarter. This has been lifted by better-than-expected economic growth numbers from Europe, the US and China. 

And while the global manufacturing sector has experienced a slowdown amidst ongoing US-China trade tensions, the service sector has shown some resilience on the back of rising consumption. The latter is being driven by strong labour markets as well as real growth in consumer incomes across many developed countries.

UPDATED 2019 INVESTOR OUTLOOK

At the beginning of 2019, Citadel highlighted four key factors that we felt would influence the outlook for year, namely: the US Federal Reserve’s (Fed’s) decision on interest rates; stimulation from China; trade wars; and South Africa’s election outcome. Now, halfway through 2019, it is worth pausing briefly to reflect on how these four factors will effect markets over the next six months:

1.  The Fed:

 

Chairman Jerome Powell stressed earlier this year that the Fed would be adopting a more patient stance to interest rate hikes, and placing further increases on hold. Then, in June, he noted that the Fed would seriously consider taking action in the form of interest rate cuts on the back of trade tensions and slowing global growth. This offered further support and stimulation to the local and global economies. Markets have already priced in a cut for July, which should see a slightly weaker US dollar and offer some relief to emerging markets.

2.  China:

 

China’s government has implemented aggressive stimulation measures this year, which will be supportive of global trade throughout the rest of the year. These measures will also provide some relief for emerging markets, while keeping Chinese growth above the government target.

 

3.  Trade wars:

 

While the US and China agreed to re-open negotiations following the recent G20 summit, it remains to be seen whether their trade discussions will actually reach a resolution. However, Trump needs a favourable trade deal with China in the run-up to the 2020 elections, which may encourage him to finally strike a deal.

4.    Local elections:

 

South Africa can finally tick the election box, after a long build-up to the polls. And, subsequent to the vote, the country recorded another positive when the size of the cabinet was reduced, as promised. That said, it is now time for President Cyril Ramaphosa and his government to finally move from talking to delivering on his many other election promises.

With these four points in mind, and the challenges they pose, the global economy should still achieve growth of around 2.8% this year. This will be more than enough to support company profitability and an appetite for risky assets. 

While numerous risks remain, global economic fundamentals have remained reasonably healthy and are continuing to improve after the recent cyclical slowdown - contrary to market fears of an imminent recession. And despite an increase in volatility, global and local markets have demonstrated strong year-to-date returns. Even more importantly, company earnings have continued to improve. 

TRUMP THE TARIFF MAN

Trump’s obsession with tariffs continued to manifest itself throughout the first half of 2019 as he not only picked a fight with China, but also threatened countries as far-flung as Europe and India, as well as neighbouring Mexico. Trump’s ability to wield tariffs as a weapon against various participants in the global economy will prove a key factor in deciding whether or not he is politically trumped during in the upcoming 2020 elections. The final outcome will certainly be interesting to watch. 

Despite a protracted government shutdown over December 2018 and January 2019, coupled with ongoing trade tensions, the US posted a stronger first quarter than expected, with GDP growth above 3%. This momentum is unlikely to continue given the many temporary factors supporting this growth, however US economic fundamentals on the whole remain very healthy with unemployment reaching a 50-year low and real wages continuing to increase, thereby driving strong consumption. 

Nevertheless, there are signs that consumers and businesses are beginning to feel the pinch of higher tariffs, as June saw consumer confidence fall to its lowest point in two years, while the US manufacturing sector remains under pressure. As a result, Business America, which represents around 600 companies and industry trade associations, came out recently to publicly urge Trump to resolve the ongoing trade issues with China, pointing to the stalemate’s negative cost impact on American businesses and consumers. 

Ultimately, Trump needs a favourable deal to appeal to his voter base and deliver on his promise to move manufacturing jobs back to the US. This is essential if he hopes secure another term in office. However, the process of switching supply chains doesn’t happen overnight, and, moreover, the US currently isn’t competitive in terms of global manufacturing standards. For example, the average wage for a Mexican worker is US$2 an hour while a US worker commands US$26 an hour. 

The US is fundamentally a service-based economy, and nearly all jobs currently being created are in the service sector. By attempting to change the structure of the economy to favour manufacturing, Trump’s efforts could ultimately cost the US more in inflation, especially as employment and real wages in the country have continued to rise. 
 
The risk, therefore, remains that the Fed’s imminent decision to cut interest rates could be a misstep. While such a move may help to delay a global recession and boost markets, should inflation subsequently rise then  it may be too late to start hiking interest rates again in an effort to stop the US economy from overheating. 

Nonetheless, strong fundamentals mean that the US still offers a healthy economic environment for investors, and should achieve growth of at least 2.5% in 2019.

ONE STEP FORWARD, TWO STEPS BACK FOR EUROPE

Europe essentially remains stuck between a rock and a hard place in terms of implementing economic reforms, as it continues to grapple with geopolitical headwinds while still attempting to achieve economic growth closer to capacity.

 

That said, expectations of a rebound continue to grow, as both investors and consumers seem to be more confident that Europe’s growth trajectory is bottoming out. In more good news for the region, the European Central Bank (ECB) has not only announced its willingness to provide further stimulation as and when needed, but has further committed to providing a liquidity injection to the fragile banking sector during the second half of the year. In addition, Christine Lagarde, who is well-known for her dovish stance, has been nominated to succeed Mario Draghi as the ECB President.

However, numerous structural issues continue to plague the continent, including an ageing population, a vulnerable banking sector and a private sector that seems more focused on building savings than investing. Europe thus remains unlikely to shoot the lights out economically, despite an easing in the ECB’s monetary policy. 

In addition, it is worth noting that the region has been highly reliant on Germany as its largest economy for growth, and particularly the German manufacturing sector which has been met with a number of challenges over the past year. These include ongoing trade wars, the slowdown in emerging market demand amidst a risk-off environment, and competition from emerging markets in terms of cost-effective production. In the year to date, Germany has posted its weakest performance in six years, also placing a cap on the European Union’s (EU’s) growth prospects. 

The rest of 2019 is likely to see Europe wrestling with issues such as Brexit, trade tensions and geopolitical troubles such as growing populist movements taking hold in Italy and Spain, as well as French President Emmanuel Macron’s promise to cut taxes for the middle classes to keep the yellow vests at bay. Given that economic growth is not recovering to the extent that was hoped for, the increasingly frequent promises by various European leaders to spend more money placating citizens is bound to place the EU under enormous financial pressure, thereby heightening the region’s financial vulnerabilities. 

Given the more accommodative stance of the ECB, Europe’s economy is unlikely to fall flat, but growth for rest of this year will remain muted at around 1.5% with risk to the downside. This is well below growth projections for the US, even though the two regions were growing in tandem just a few years ago. 

CHINA REMAINS UNDETERRED

Chinese Foreign Ministry Spokesman Geng Shuang was recently quoted as saying: “China does not want to fight a trade war, but we are not afraid of fighting a trade war.” This emphasises yet again that Trump’s trade war opponents are not weak contenders. In fact, China is willing to battle it out with the US to ensure that any trade agreement is mutually favourable.

 

Furthermore, the Chinese government is much more open to business and has demonstrated that it is very willing to deal with the rest of the world, which could make it difficult for Trump to win concessions within a trade agreement.

 

The Chinese manufacturing Purchasing Managers Index (PMI) dipped to its lowest point in a decade in June, demonstrating the strain that tariffs have placed on industry. However, the government has all the ammunition its needs to stimulate the economy even if trade tensions continue, which could prove to be a blessing for the rest of the world. 

Also worth noting is that while previous surges in stimulation remain focused on exports and infrastructure, as seen in 2008 and 2015, this year’s focus has shifted towards consumers, businesses and the private sector, signalling the government’s new vision for economic growth.  

Monetary and fiscal stimulus measures have already borne fruit in the retail sector, which saw a definite uptick at the beginning of this year on the back of various tax cuts, including a VAT reduction from 16% to 13%. 

There are some lingering concerns that the continuation of trade tensions could increase the risk of a global recession, especially as the Chinese government has made it clear that it will protect the interests of China, and Chinese firms. However, a Chinese stimulus will also offer some support to the rest of the world, and especially emerging markets. Furthermore, unlike Europe, Japan and to a certain extent the US, China has more than enough monetary and fiscal firepower to keep stimulating its economy and maintain its current levels of growth.

China’s economic policies remain distinctly pro-growth, with total fiscal stimulation measures approaching some 2.5% of GDP, which should underpin the country’s outlook for the next six months. Government’s 6% growth target is, therefore, easily achievable even if trade issues continue. 

SOUTH AFRICA: TIME TO STOP TALKING (AND DREAMING) AND START DOING

With the national elections and cabinet appointments finally behind us, now is the time for Ramaphosa and his government to stop talking and start implementing the numerous reforms that have been promised.  

The next 12 months will be absolutely crucial for South Africa, and it is even more noteworthy that they are playing out against a backdrop of very real economic challenges. The new administration certainly finds itself in an incredibly difficult position. 

The South African Reserve Bank’s (SARB’s) latest quarterly bulletin revealed that economic growth has been in its longest declining cycle since 1945, while our local manufacturing PMI has remained below 50 since the beginning of the year, the weakest reading since 2009. 

These figures demonstrate the consequences of economic mismanagement over the past decade and, after a poor GDP print of -3.2% in the first quarter of the year, the question now is whether South Africa is heading for another technical recession. Our own expectation is that South Africa will just miss a technical recession, as the first quarter’s results were exacerbated by factors such as strike action in the mining sector, a decline in exports, manufacturing, mining and retail on the back of a soft patch in the global economy and aggressive load-shedding in February and March.

 

In the year to date, blackouts have shaved more than 1% from South Africa’s economic growth, placing the country in an extremely dangerous fiscal position. While government initially targeted growth of 1.5% this year, the SARB now anticipates that economic growth will only reach 1%, implying that all the fiscal metrics budgeted for in February are likely to be weaker than expected. 

Seen together with the numerous, well-publicised financial issues at the country’s state-owned enterprises (SOEs), including South African Airways, the SABC and, critically, Eskom, it is clear that the country’s fiscus is at severe risk. 

On this front, National Treasury recently stated during a meeting with investors in London that it was more important for Eskom to survive than for South Africa to avoid a credit rating downgrade. While it is true that it is meaningless to avoid a downgrade if there’s not enough electricity supply to propel the economy forward, this point demonstrates government’s willingness to support SOEs even if it means a downgrade to junk status.

All this said, there are some green shoots in the local economy which offer some reason for hope.

Ramaphosa delivered on his promise to reduce the cabinet, cutting the number of ministers from 35 to 28. There is still room for further reductions, however, given that the global average is 15 cabinet members.  

Additionally, the State of the Nation Address (SONA) was fairly well-received, although the general consensus was that government needs to stop “dreaming” and move from talking to doing; something Ramaphosa himself admitted.

 

The top priorities for Ramaphosa’s government over the next 12 months will include:

Some more positives to arise from the SONA included the re-affirmation of the SARB’s mandate and the news that foreign direct investment (FDI) is picking up again with 2018 recording the highest FDI numbers over the past five years on the back of renewed confidence and trust. Ramaphosa mentioned that around R300 billion was pledged during October 2018’s Investment Summit, of which R250 billion is already in implementation. If this trend continues, it will create the foundation for more sustainable growth in the future.  

Additionally, weak global growth, the U-turn by central banks on monetary policy and the Fed’s imminent interest rate cut should also pave the way for the SARB to reduce interest rates soon; this would lend South Africa additional momentum for the second half of the year.

However, a weak first half and lingering structural issues mean that South Africa will struggle to achieve the 1% growth target this year. We expect this figure to rather inch closer to 0.8% – that is, if we are able to avoid any further load-shedding.

 

Depending on government’s ability to deliver on promised economic reforms and on the management of the SOEs, growth could hopefully rise to 2% within the next two to three years. While 2% still may not be enough to address key issues of poverty, inequality and unemployment, it will at least be a move in the right direction. 

Finally, the rand has drawn a great deal of attention over the past few months. Over the short to medium term it will continue to track any developments in global trends, especially any news on the trade war front. However, despite its recent bout of strength, South Africa’s low growth environment, coupled with our numerous structural and fiscal challenges, suggests that the local currency should remain under pressure over the medium term. 

Any changes in global risk appetite will continue to push the rand only temporarily in either direction. Ultimately, markets will need to see the country resolving its fundamental issues if the local unit is to strengthen in a more sustainable manner. 

Stimulating jobs and reducing unemployment

Resolving the land issue, offering certainty on land expropriation and making progress in terms of equitable land redistribution

Restoring the balance sheets, operating capacity and competitiveness of SOEs, of which Eskom remains top of mind

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PREPARING FOR A VOLATILE ENVIRONMENT

Anticipated global growth of around 2.8% in 2019 should create a reasonable environment for companies to maintain their profitability, extending support for risky assets. However, increasing uncertainty, geopolitical issues and trade tensions mean that investors need to brace their portfolios to deal with rising levels of volatility.  

The preservation of capital is the first priority in these conditions, as preserving capital amidst market downturns is key to generating superior compound returns over time, thereby ensuring that portfolios outperform their respective benchmarks. 

We are, therefore, gradually increasing the proportion of stable components in cash-matching portfolios for clients who need to draw an income from the portfolio on a regular basis. To this end, we are allocating around two years’ worth of required cash flow in order to help clients weather the potential storm and reduce their portfolio risk to match its cash-flow liability. 

In terms of growth, international cash and bonds generally do not represent an attractive prospect as a safe haven at this point in time, as the U-turn by central banks together with low interest rates means that these investments are not offering any real yields. More than 40% of developed market bonds continue to offer yields below 0%, including Germany whose long-term bonds recently traded around yields of -0.3%. Thus,  investors need to look to alternatives to reduce portfolio risk while still offering some upside potential and positive yield. 

By contrast, local cash is offering quite attractive yields and, in fact, South Africa is currently one of the highest real-yielding countries in the world. So, for tax-friendly vehicles such as pension funds, provident funds, retirement annuities and tax-free savings accounts, interest rates of around 8.5% represent an attractive opportunity. 

Local bonds are likewise quite attractive in relation to inflation, but we are concerned that bonds have not priced in the full risk of a potential default by SOEs. The spread on SA bonds has increased significantly of late, compared with the short end, implying that investors have begun to price in potential problems with SOEs. We will, therefore, continue to remain underweight local bonds and will focus on short-term instruments until we feel that bond yields better reflect the real underlying fiscal risks that South Africa government and SOEs are facing. 

Turning to equity, a strong rebound by SA Inc will depend on whether real structural reforms are finally implemented to support industry and lift business and consumer confidence. In good news for the JSE, however, the fact that SARB is finally in a place where it can afford to start cutting interest rates normally bodes well for performance over the next few months. 

However, we still prefer global to local equity, as most other regions are achieving far greater economic growth than South Africa and are constrained by fewer structural issues, meaning that foreign companies are generally achieving much higher levels of profitability. Despite the fact that most markets appear quite elevated, a closer look at price earnings ratios shows that share prices are being backed by higher earnings, so valuations should not currently be the only source for concern. 

Given that we have entered a difficult stage of the economic cycle, we remain focused on buying more defensive stocks that have the potential to serve clients well over the longer term in terms of both creating and protecting wealth. In particular, we are looking towards companies headed by dynamic global leaders that have the ability to successfully adjust to a world of disruption. 

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