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Home / Investment Insights / Q1 2017 – Economic Commentary

Q1 2017 – Economic Commentary

A weekend is a long time in South African markets. On the penultimate Friday of the month we had been examining research that suggested that the South African bond market was one of the most favourable around the world. On the subsequent Monday bond yields moved 7 points lower during the morning before reversing course and trading more than 20 points higher at lunchtime. The rand retraced from levels of about 12.30 to the US dollar in the morning, to about 12.60 at lunchtime. Gold traded higher about 1.3 percent by the end of the day, and the rand had by then moved to about 12.75 to the US dollar. The cause? An announcement had come over the wires that Finance Minister Pravin Gordhan and his deputy, Mcebisi Jonas, had been recalled by President Jacob Zuma from a roadshow to meet with UK and US investors. The reason given was that it was an unauthorised trip. As the day wore on, whispers were that Gordhan was going to be moved aside in favour of ex-Transnet and Eskom boss, Brian Molefe.

By Wednesday, the rand had travelled up to 13.11 against the dollar before recovering to about 12.93 to the dollar, all on the back of speculation and rumours. The president’s intentions are widely assumed to be connected to his associates, the Gupta family, who were caught in a race to secure their banking lines before their last remaining banking relationship terminated at the end of the month.

Under normal circumstances, such a recall would raise eyebrows, but in South Africa’s current political climate, such an action takes on greater proportions. It is not merely a question of whether investors will take invitations to subsequent meetings seriously, it is also a question of whether published budgets and their associated capital raising plans have legitimacy in South Africa. It is an own goal of considerable proportions: South African risk assets have benefited from weakness in the US, for example. The failure of President Donald Trump to guide his party to passing a new revamped health care bill in the US despite Republicans controlling the White House and both chambers of Congress, caused US risk assets and the currency to trade weaker. The weakened outlook on the US combined with a market view that South African bonds were attractive, supported strength in both bonds and the rand. Cabinet politics in South Africa have placed those gains at risk.

Overnight between the last Thursday and Friday of March, President Jacob Zuma reshuffled his Cabinet, in the process firing the Minister and the Deputy Minister of Finance. It was a move that was widely and intensely criticised; the country’s Deputy President took the unusual action of publicly criticising the decision, as did the Secretary-General and the Treasurer-General of the ANC. The financial markets were also critical with the rand losing further ground to end the month at 13.41, yet despite the weakness in the currency and bond yields, the reaction of the financial markets was not as bad as initially feared. It appears that the emergence of senior politicians openly opposing President Zuma suggested to investors that there was political will to resist the direction he was seeking to take government in. Furthermore, some yield seeking investors appeared to view the weakness in the currency and in bond yields as merely affording them a cheaper entry point into South African risk assets. As at Friday, 31 March 2017, South Africa’s foreign debt was still rated at investment grade by the major credit agencies and the team at National Treasury had not yet abandoned ship. These were very likely important data points in the willingness of investors to continue to engage in active two way trade in bonds and the currency.

The risk that South Africa faces is not merely to the opportunities of financial investors to make gains on their capital. The risk is also to placing the country on a firmer economic footing as the economic cycle shows signs of swinging upwards. At a meeting after the Budget speech, members of the National Treasury acknowledged that some of the stress upon economic growth had been relieved by a less negative net imports position. Slowing growth tends to reduce imports and so this was a consistent development. However, as growth in consumption and investment picks up, imports will rise because consumers will desire imported consumer goods and businesses will require imported capital goods. A more favourable currency exchange rate will bolster the elasticity for such goods as they can be obtained at improved prices. The demand side of the economy needs these sorts of favourable winds especially now that there are questions arising about the ability of the supply side to continue to support local incomes. A case in point is the recent observation of made by a strategist with Hong Kong-based financial services group, BOCOM International, that the firm has noted that high frequency Chinese data such as retail and car sales that are weaker than expected, and that stockpiles in China of resources that South Africa supplies into the international market have risen substantially. Iron ore stockpiles at Chinese ports are currently at about 124.29 million tonnes from an end of December 2016 level of 103.03 million tonnes. Looking back over a decade, current iron ore stockpile levels are approaching twice the roughly 75 million tonnes average, and have already exceeded the previous peak in May 2014 of 113.07 million tonnes.

Julius de Kempenaer has created a visually arresting proprietary measure of relative strength that plots a calculated ratio on one axis and the momentum of that same ratio on a second axis. The result is a 2-dimensional plot with quadrants. Then a snail trail can be constructed of the movement of an asset over any period, on the chart. For South Africa, we have observed the snail trails of 8 sector groups over a 12-week period. Of those eight, Information Technology had stopped weakening and was starting to improve over the last 2 weeks, while Health Care and Consumer Services were two other groups that had showed improving momentum. The other five sector groups – namely, Basic Materials, Consumer Goods, Financials, Industrials, and Telecommunications – were clearly weakening and in the case of Basic Materials the sector was beginning to lag. What the snail trails of Relative Rotation Graph acknowledge is that sectors do not all rise at the same time, but the chart also shows a disturbing tendency of weakness in positive momentum. We must bear in mind that these charts reflect something about share prices and that must be distinguished from the real economy. Yet, if we were to contend that the real economy is looking brighter than what share price momentum suggests, then the actions of South Africa’s political class are placing even that side of the picture in jeopardy.

In times of jeopardy, conventional wisdom holds that gold alongside the US dollar, the Japanese yen and the Swiss franc, is a safe-haven asset. In our core equity portfolios, we have held no direct gold positions and in our multi-asset portfolios we have very small positions in relation to the sizes of the funds. In theory, gold fulfils its “uncertainty hedge” function both in times of high inflation or collapsing markets. In practice, gold does best when confidence is collapsing and asset prices are declining, thus gold bugs are roughly right on the “collapsing asset prices” half of the equation. In periods of benignly rising inflation the situation is less clear. When inflation is benign and real rates are positive, there is a quantifiable opportunity cost to holding gold. This is the situation we face at the moment; inflation expectations are within the target range and so a large gold position does not shield investors from anything remarkable in inflation terms. Although not an exact match for looking 5 years into the future, comparing the yields on the nominal R208 and the inflation linked R212 yields a useful approximation of expected medium term inflation at about 5.9 percent. Of course, when inflation rises too much and seemingly beyond the reach of central banks to control it, the situation can cause anxiety in capital markets sparking concerns of an imminent decline in the value of financial assets. It is at that moment that gold once again begins to shine. Thus, gold appears to be a partially relevant store of value and less directly a continuous hedge against inflation. In South Africa, inflation is expected to move lower through the course of 2017 making the inflation-scare attractiveness of gold, dull. Indeed, the Misery Index which is a sum of inflation and unemployment rates, has been coming lower this year in South Africa, and is expected to come further down. As for a collapse in markets, that would likely happen in conjunction with a decline in markets around the world. At present, we assess that likelihood as reasonably low, because though OECD gross fixed capital formation is flat-lining, capacity utilisation rates remain healthy in South Africa, Europe and the United States. Despite the legislative setback that Trump has suffered on the health bill, we expect Republicans to come back fighting to deliver on defence and infrastructure spending. The fly in the ointment remains China, as we have highlighted over the past few months, more so because while the US promises to stimulate demand, China is known to be more effective in getting it done.

We have pointed out above that iron ore stockpiles are growing at Chinese ports. Some China watchers are of the view that the property-investment cycle is close to the peak, leaving fewer destinations for the steel that might come from all that iron ore. We ourselves have previously taken the view that China’s intent to reduce pollution and drive steel-milling efficiencies will necessarily reduce the throughput of iron ore in the near to medium term. If Chinese markets increasingly come around to our view that the risks are that China will underwhelm on its growth targets, then Chinese shares could drop substantially as they did between June and August 2015. It is interesting to note that the Shanghai Composite has more-or-less traded sideways relative to its August 2015 levels. We believe that this is in part because of systemic issues that have yet to be satisfactorily resolved – in particular, a substantial expansion in debt directed through the banking system.

Chinese credit-to-GDP continues to expand but most recently the Chinese unit has stopped losing ground to the US dollar and Chinese foreign reserves have stabilised after two and a half years of reductions. Capital flows out of China continue but at apparently lower rates that can be funded out of forex earnings. It may also help that China has trained a keen eye on some offshoring schemes that have taken off in recent times. Tiny Pacific islands such as Saipan, and larger islands like the Philippines and Australia have become popular with big spending gamblers who effectively recycle Chinese money into other currencies.

From a macroeconomic perspective, we thus find ourselves comfortable with the opportunities for South Africa for as-long-as the politics remain out of the way or are resolved in a manner that maintains fiscal discipline as a central tenet. Overseas we consider the pressure to be on US lawmakers to protect growth, and we see Europe ticking along neatly with some gentle tapering in prospect. The US Fed has done its part, delivering a rate hike that was fully expected by the markets and then adding a dovish statement that ignited risk assets. We are cognisant of Chinese risks but do not yet see Chinese markets collapsing and bringing global risk assets lower with them. At the beginning of the year we pointed out that we think it would be wise to closely watch the unfolding of ANC politics in this key year for internal party politics. The stakes are high with whichever grouping that wins potentially setting the policy agenda for the next decade.


Source: Tony Bell – KI, MiPlan; Fund Manager & CIO, Vunani Fund Managers

Nothing expressed in this commentary shall be construed as advice and no liability accepted should any reliance be placed on the information provided.  All disclosures and conditions as set out on shall apply and such commentary is read assuming acceptance thereof.