Chief Economist and Advisory Partner
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.
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.
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.
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.