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Jan 10, 2016

Where is the boom amongst the gloom?

Where is the boom amongst the gloom?

Overview

The 2016 “Happy New Year” greetings faded swiftly this year as the collapse of equity markets globally hints at a difficult year ahead for investors. US equity investors experienced the worst first week in a year ever as the S&P500 fell 6%. Fears of an imminent economic crisis in China, credit defaults, oil collapse, US recession and geopolitical shocks have gripped the market.

Even billionaire investor George Soros recently warned; “I would say it amounts to a crisis. When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008.” He was talking about China’s economic adjustment challenge and financial market concerns.

One has to view Soros’ comment in the context of another of his famous quotes; “The financial markets generally are unpredictable. So that one has to have different scenarios… The idea that you can actually predict what’s going to happen contradicts my way of looking at the market.” Mr Soros highlighted the magnitude of challenges that China faces, however how and when China will overcome these challenges is largely unpredictable.

Our own view is that the number of risk factors and uncertainty has increased, and to reflect this investors require a higher risk premium, which is reflected by lower asset prices. How big should the risk premium be? Current market volatility suggests that market participants are still figuring that out. When we analyse these risk factors against asset prices and market volatility we conclude that too much gloom has been priced in for 2016. We see a low the risk of the major economies; namely US, Europe, China & Japan, going into recession. Together they make up more than 60% of world GDP and contribute around the same amount of world growth. These economies will remain strong enough to support global growth due to the following factors;

 the major central banks remain accommodative with easy monetary policy;

 the scope for fiscal support from governments in major economic regions has increased; and

 lower commodity prices benefit global consumers and reduce the cost of growth.

Outside of the major economies we are in a crisis led by the fall in commodity prices, currencies and credit quality. I have elaborated on this in a piece I did in July called What’s up with commodities. In short, demand supply dynamics in commodity markets will only rebalance once producers cut or exit production which implies job losses, defaults and economic reforms. The self-reinforcing cycle of lower commodity prices, weaker growth, weaker currencies and higher interest rates in commodity-producing countries will remain a challenge for commodity-producing countries and sectors and a source of bouts of risk aversion.

Before we review the major risk factors, we set out our outlook for South Africa and economic growth forecasts for 2016 relative to consensus. On aggregate we remain more optimistic than consensus on developed markets growth and less optimistic than consensus on emerging markets growth. China is the exception where we believe growth will be marginally better than forecasted by the market.

Happy New Year!

Global Outlook 2016 Q1-2016

South Africa Outlook

South Africa has made many headlines recently, mainly for the wrong reasons as credit agencies downgraded their ratings outlook for South Africa and a series of political events shocked investor confidence in the county’s institutional framework. Concerns about China, credit and commodities continued on the external front, while the US Federal Reserve raised interest rates for the first time in a decade.

As a result Rand weakness accelerated, interest rate expectations were revised higher and equity prices fell as investors required a higher risk premium for owning local assets. South Africa’s trade linkages with China, commodity prices and the Federal Reserve’s interest rate policy will be important factors, while domestically the February budget and mid-year municipal elections will be closely watched to gauge future policy.

The Rand has weakened beyond its normal trading range and we expect the currency to strengthen back towards its 5 year trading range, although the timing is dependent on external and domestic risk factors.

Screen Shot 2016-08-04 at 5.30.16 AM

 

The primary objective of the South African Reserve Bank (SARB) is price stability. To that end, SARB governor Lesetja Kganyago will continue to keep a watchful eye on inflation expectations. The steep depreciation of the Rand over the last 12 months and risk of rising food prices due to severe drought will prompt the SARB to hike interest rates over the year. We expect the policy rate to increase by 100bps.

We expect fiscal policy to tighten further. The re-appointment of Pravin Gordhan as finance minister has given him the necessary prerogative to reverse the course towards a sub-investment grade country credit rating. The February budget will likely introduce further tax hikes and spending cuts.

The outlook for household consumption has deteriorated. Job losses in the mining and agricultural sector, utility price increases, food price increases, higher interest rates and taxes will weigh on the consumer, especially those in the medium to lower income bracket. The drop in the oil price and increase in public sector wages will continue to support consumption but may not be enough to offset the pressures on consumption as higher fuel levies and weak currency have reduced the benefits.

The cyclical growth factors; external demand, tighter monetary and fiscal policy, combined with a weaker consumer, does not bode well for overall growth. Structurally, the country still has a lot to do to increase the potential growth rate. Electricity and labour supply constraints need to be addressed and greater focus should be put towards the service sector to benefit from the weaker Rand. We believe the economy will grow at around 0.8% in 2016. Given that 2016 is a municipal election year, I doubt that difficult reform decisions will be taken. Politically the country has passed an important test in December last year to assert the independence and strength of our fiscal and monetary institutions. The re-appointment of Mr Gordhan to finance minister is a signal to the world that the economic well-being of the country is respected by the broader leadership in both the public and private sector.

Global Outlook 2016 Q1-2016

Global economic growth forecasts Economic Forecasts % of World 2015 GDP 2016 GDP 2016 GDP
Country GDP Growth Consensus Forecast
United States 23% 2,4% 2,4% 2,2%
Europe 16% 1,5% 1,6% 1,7%
Japan 5% 0,6% 1,0% 1,0%
China 15% 6,9% 6,5% 6,6%
South Africa 0,4% 1,3% 1,3% 0,8%
Emerging Markets 40% 4,0% 4,6% 4,2%
Developed Markets 60% 1,7% 1,9% 2,0%
Global 3,1% 3,3% 3,2%
Source: IMF, Wold Economic Outlook. Bloomberg estimates and forecasts as at 19 Jan-2016. Share of GDP expressed in nominal $ terms.

 

Jacobus Lacock

Macro Strategist

Multi Strategy Team

@fairtreeCapital

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