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Aug 12, 2016

Shifting policy and political paradigms

The shift towards fiscal policy to enact reflation

Over the last 24 months the global economy had to confront a series of deflationary forces. The price of oil fell 60%, commodities fell 40%, the US dollar strengthened broadly by 20%, and Chinese policy and growth fears led to softer global manufacturing and concerns around the credit quality of commodity producers.

Future inflation expectations continue to fall despite accommodative monetary policies

 

Deflationary pressures peaked earlier in the year, markets tumbled and many feared the world was heading towards a recession. Policy makers were forced to respond to dissolve the negative deflationary and macro pressures exerted on financial markets. The US Federal Reserve refrained from hiking interest rates, while the European Central Bank dropped interest rates further into negative territory and increased their asset purchase program to include corporate bonds. The Chinese central bank also acted by clarifying its own policies.

Growth and financial markets stress recovered from the first quarter

 

O2

Markets recovered and economies proved to be more resilient than many believed. After years of shoring up financial markets risk with tighter regulation and accommodative monetary policy, it was encouraging to see how well the global financial system coped with the amalgamation of risks early in the year. Signs of reflation emerged during the second quarter; the US economy benefited from a weaker US dollar and overall easier financial conditions, China’s industrial economy benefited from brought-forward fiscal spending that boosted infrastructure and property investment and in Europe economic activity reacted positively to the ECB’s latest round of easing. With an improved China backdrop and weaker US dollar, positive sentiment around emerging markets and commodities started to develop and prices started to rise.

Oil surplus and strong US dollar have been key deflationary forces

 

O3

In our view the culmination of the deflationary pressures experienced this year have predominantly been a result of oversupply, excess capacity and a strong US dollar rather than recessionary forces, and consequently our view of world is relatively constructive. The price of oil should continue to grind higher towards equilibrium, in our view $45-$55, still far below the $100 levels seen earlier in the decade. Lower oil prices continue to benefit households despite the deflationary effect it had on inflation. We view current oil dynamics as reflationary.

Oil market close to equilibrium (million barrels per day)

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The reflationary effect of oil on inflation

 

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Just as the scale was tipping away from deflation to reflation, the outcome of the Brexit vote tilted the weight back towards deflation. The expectation of lower growth and increased political uncertainty in the UK and Europe paired with a stronger US dollar saw global bond yields fall further, many into negative territory.

The US dollar may strengthen further as the European Central Bank, Bank of Japan and Bank of England embark on a new round of policy easing to boost inflation, while the US Federal Reserve look to increase interest rates further. How should policy makers deal with persistent deflationary pressure? Monetary policy alone may not be enough to reflate global economies. Outside the US, it had limited success thus far.

Central banks may continue to use their current monetary policy tools; interest rate cuts, asset purchases and negative interest rates, but they are slowly running out of ammunition and global growth remains at or below trend. The Bank of Japan may soon own more than 40% of the Japanese government bond market and is buying more government bonds than being issued monthly, yet weak growth and deflation remain a concern. Europe may face similar challenges soon. Fiscal policy has to start playing a bigger role. Globally policy makers may start to warm up to the idea of coordinated monetary and fiscal policy. The most simplistic form would be to increase fiscal spending on infrastructure and technology while the central bank continues with its asset purchase program. On the other end of the spectrum it may imply that central banks have to print money to directly purchase the government debt issued to fund fiscal spending. The challenge with this approach is central bank independence and credibility. Policy makers may slowly start to move towards coordinated monetary and fiscal policy. Japan will most likely be the first, followed by Europe, UK and the US.

Commodities and real assets should benefit in a world where fiscal policy plays a much bigger role and the need for low interest rates diminish. Both are key elements to inject reflation back into the global economy. The other attractive side to this policy framework is that fiscal spending may improve the wellbeing of those that felt left behind from the asset price inflation caused by multiple rounds of quantitative easing. It may be government’s answer to the rise in the global so called anti-establishment movement.

Political shifts add risk premiums

Geopolitics is shifting towards multipolar economic and political power, away from the hegemony system in which the US dominated world power and most nations accepted to preserve peace and the status quo. The rise of China, Middle East tensions, Eurosceptism and failure of bipartisanship in the US are prominent signs that a new multipolar equilibrium of political and economic power is in the making. In a multipolar system, regional powers pursue policies independently. Global problems are only addressed in coordination when they become too serious. Should this rapidly changing geopolitical landscape increase the risk premium on risky assets?

The growing economic influence of Chinese policies, political crisis in Europe and surprising Brexit vote in the UK, have all added to market volatility recently. Investors looking for higher yielding assets were also reminded by the failed coup in Turkey, that geopolitical risks combined with complacency could compromise expected returns. Even in South Africa and Brazil domestic politics have raised concerns despite being prominent developing countries with solid institutional frameworks. The rise and changing dynamics of terrorism adds another component to an increasingly volatile geopolitical landscape. When market participants assign a risk premium incorrectly it creates an opportunity for investors to benefit. Brexit, Grexit and Nene-gate are a few examples where too much risk premium was priced in by the market.

Geopolitical volatility reached new highs earlier in the year

 

O6

Did South Africa receive too big a risk premium from the market post the commodity downturn and Nene-gate debacle? Judging by South Africa’s credit default swap spread (the cost of insurance against a default), it appears so. The average BB rated country in the graph below has a CDS spread of 220, while South Africa rated BBB- is trading at 252, already reflecting a downgrade.

South Africa already priced for credit downgrade relative to the other emerging markets (5yr CDS)

 

O7

Looking forward to potential risks; Chinese policies will become more important as authorities move closer to open up currency and capital markets, the disputes around the sovereignty of islands in the South China Sea also need close attention as more than 50% of world trade passes through that area.

In Europe, France, Germany and Netherlands face elections over the coming 12 months. Spain still struggles to form a new government while Italy faces a referendum on constitutional reform in October. Given that the EU would not want to compromise its status any further after the Brexit vote it may act hard on the UK while trying to improve the attractiveness of the European Union. The key risk for the UK is its ability to export goods and financial services competitively to the rest of the EU and the world. We doubt that the eventual deal with the EU would be negative for the UK’s status as financial powerhouse and long term growth prospects. However, short to medium term uncertainty will weigh on business investment as we may not see Article 50 (the document that outlines the UK’s will to leave the EU) triggered during the next 12 months.

In the US the rise of Donald Trump surprised many, but similar to UK voter sentiment, he has gathered support from those impatient with centrist policies which failed to deliver broad economic welfare. It is less clear if, and how negative a Trump outcome will be for the US economy. In many ways his policies may improve growth over the medium term, if he chooses to embark on a path of fiscal spending.

Global Outlook

 Global economic growth forecast

O8

United States outlook

Economic growth has moderated over the last few quarters, but remains at or slightly above trend. On a relative basis the US economy is the strongest developed market economy and the engine of global growth. The key positive contributors to growth; household consumption, residential investment and government spending, have all benefited from near zero interest rates, the low oil price and accommodative policies. In our view the US economy will continue to grow above trend for the next 12 months despite the potential for lower growth in Europe as a result of Brexit. The US is a fairly closed economy, exporting less than 2% of its GDP to Europe.

Easier financial conditions will  continue to boost growth

O9

The US Federal Reserve will be slow to raise interest rates and monetary policy should remain very accommodative for the next few years. We only see one more rate increase for the remainder of 2016. On the fiscal front, the government has scope to increase spending regardless the outcome of the US presidential election, although it may come earlier and larger under Trump given that it is more likely that we will see a Republican dominated House and Senate under him. Overall financial conditions are supportive of growth and should support household consumption and manufacturing.

The softness in US growth we saw earlier this year has been a result of US dollar strength, very low commodity prices and concerns around the quality of credit globally. These risks translated into tighter financial conditions and weaker consumer confidence and spending. We remain constructive on US household consumption despite a softer first quarter. One encouraging sign from the first quarter was that the savings rate has increased along with an increase in disposable income, as consumers chose to save a greater portion of their income. Some of this pent up demand should reverse over the rest of the year. Consumer confidence is on the rise and the economy continues to absorb private sector jobs at a pace of around 200K per month, pushing the unemployment rate below 5%. Evidence that labour market conditions are tightening should push wage inflation gradually higher over the next few quarters.

US household balance sheets are in good form. Unlike the previous economic cycle, households continue to deleverage, taking on less debt, despite a meaningful increase in their net worth.

US consumers are wealthier and have less debt than during the previous economic cycle

O10

China outlook

The growth trend continues to slow as a result of much needed economic reforms. Chinese authorities have dropped the growth target from 7% in 2015 to a 6.5% – 7% range for 2016. We expect economic growth to slow gradually over the long term but recognise that economic activity has stabilised recently as the government stepped in to increase fiscal spending. We believe these measures along with stronger credit growth and accommodative policies will support Chinese growth. We are also less concerned about China’s debt situation and policy framework.

Early in the second quarter the Chinese government announced plans to invest in the country’s ailing northeast provinces and to boost infrastructure in the aviation and rail industries over the next 3 to 5 years. China’s fiscal deficit as percentage of GDP has increased from around 2% a year ago to above 4%, evidence that public sector investment has been a key driver of recent growth momentum.

China has increased fiscal spending: Fiscal deficit as % of GDP

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These measures along with an increase in credit extension earlier in the year boosted real estate and infrastructure investments and supported commodity prices. We believe the positive momentum from these policy actions should continue over the third quarter but at a slower pace. Private sector and manufacturing investment remains weak but may rise as business conditions continue to improve and policy remains accommodative.

After a poor 4.9% annualised growth rate in the first quarter, the economy bounced back to record 7.4% growth for the second quarter. The economy has to grow at a 7% annualised rate for the remaining two quarters of the year to reach 6.5%, the lower end of the growth target for 2016. We therefore expect authorities to continue to support the economy via a combination of targeted monetary and fiscal policy.

The divergence between the services and manufacturing economy remains in place. The service economy continues to grow at around 10% while the manufacturing economy is barely growing although it shows sign of stabilisation.

The service economy has become the main driver of growth

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The government has to balance their growth objective with its reform agenda and has been fairly successful thus far despite some policy mishaps along the way.

China’s economy has re-balanced towards a service and domestic consumption

O13

Transparent Policy objectives ensured market calm despite recent depreciation

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Concerns around capital outflows have faded as China’s foreign exchange reserves stopped falling. There are signs that China may benefit from inflows as investors are on the hunt for yield. We also do not share the market’s concerns around China’s debt situation. China’s high savings rate, around 45% on aggregate, will inevitably lead to high levels of debt financed investments as the economy remains fairly closed. China’s total debt to GDP ratio, around 220% is not large by global standards. Countries like Australia, Canada, Malaysia, Korea, US, UK, Japan and many other European nations carry similar debt to GDP levels. When one only focuses on household debt, China’s 40% debt to GDP is small relative to most nations. The Chinese consumer, the country’s future growth engine, is thus fairly well shielded from any debt crisis. Unlike many other economies where new credit has gone into unproductive consumption, most of China’s debt has been used to build productive infrastructure. We acknowledge that bad debts have accumulated in the economy since 2009 and that authorities will be careful not to boost credit extension. Monetary policy will remain accommodative but geared towards reducing the overall cost of borrowing for corporates rather than explicit interest rate cuts.

Inflation in China remains low, but there are encouraging signs that deflationary pressures maybe lifting. Input prices are rising and monetary aggregates are stabilising along with a weaker currency and accommodative policies.

Excess Capacity has reduced: Input prices are rising

O15

South Africa outlook

The growth trajectory continued to deteriorate further as first quarter GDP growth printed -1.2% annualised, the third negative quarter during the last two years. Unlike the previous two negative prints, when mining and manufacturing had been the key detractors from growth, it was household consumption and mining that were the main causes of contraction. Consumers came under pressure as they faced high inflation, a weak currency, higher interest rates and job losses in the mining and manufacturing sectors. Economic data has also reflected weaker consumption as private credit extension, vehicle sales and retail sales deteriorated.

Consumer has been under pressure but the outlook is improving

O16

Households are less geared than during the previous cycle, therefore the fall out on the banking sector and parts of the retail market have been less pronounced.

Looking forwards we see scope for improvement. Inflation should peak within the next few months, and then fall back within the South African Reserve Bank’s (SARB) 3-6% target range early next year. Severe drought conditions and a sharp depreciation in the currency pushed inflation higher. Food prices should fall into next year and recent appreciation and stability of the Rand suggest less inflationary pressures from imports. We expect the SARB to remain on hold until the outlook for inflation clearly points to the mid-point of the target band, 4.5% at which point the central bank will consider cutting rates. This may come as early as the first half of next year. We do not expect further job losses in the mining and manufacturing sectors.

Economic activity has picked up in the mining and manufacturing sector. The weaker Rand increased competitiveness and led to import substitution. Despite falling domestic vehicle sales, vehicle exports continue to grow at a solid pace relative to last year. Domestic demand from Europe will continue to drive vehicle exports. Mining and manufacturing is also benefiting from an improving growth outlook in China.

Barclays PMI: Economic activity has picked up

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Manufacturing and mining contributes around 20% to the economy and consumption around two thirds. The outlook for the consumer has improved and recent retail sales data have surprised on the upside. We believe consumption in the second quarter would be strong enough to see second quarter GDP growth come close to 2%. Given our view of an improving global growth outlook, receding consumer headwinds and more accommodative policy outlook, economic growth may surprise to the upside over coming quarters.

The risk of a credit rating downgrade in December still looms despite an improving growth outlook. Post-election action by the government to address structural deficiencies and an improved October budget could tilt the risk of a ratings downgrade towards 2017.

Europe outlook

The outlook in Europe has worsened since the UK voted to leave the European Union. More than 40% of UK exports go to Europe. Uncertainty around the timing and negotiation of a new trade deal with the European Union and rest of the world should weigh on UK and EU business investment. The political environment in Europe remains fragile and with elections coming up in Germany, France and Netherlands, officials should be cautious to not add more fuel to rising anti-establishment, Eurosceptic sentiment.

The lower price of oil, weaker Euro and looser monetary and fiscal policies has been the major drivers of the recovery during the last two years. Domestic demand responded well and supported demand for credit, particularly mortgages. Corporate credit and non-financial credit growth expanded as lending conditions eased. Industrial production and retails sales benefited from improving economic activity. In general, Europe has surprised the market over the last 18 months. Given the result of Brexit and the political developments, one questions the EU’s ability to continue on the same growth trajectory.

EU economy is expanding at a lower pace

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The drivers mentioned above should remain in place. Policy could become even more stimulative if fiscal efforts are introduced and the Euro may weaken further. However, political uncertainty and concerns around credit losses in the banking sector may dent business confidence. We therefore remain constructive on the region with some caution. It is important to increase the performance of banks in the region. Low and negative interest rates have weighed on bank’s performance. It is important that future policy address the issue of negative interest rates. Increased fiscal spending may play an important role to help German bond yields push back into positive territory.

In Europe about 50% of sovereign debt is now yielding less 0%. Globally more than $13trn government debt yields less than 0%. Investors looking for return have to move out on the risk spectrum to corporate credit, emerging market debt and high yield and in the equity market high dividend yielding stocks are attractive. I believe policy developments in Europe would be one of the major drivers of asset returns over the next 12 months.

jacobus lacock
Jacobus Lacock , Macro Strategist at Fairtree
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