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Home / Investment Insights / Q4 2016 – Economic Commentary

Q4 2016 – Economic Commentary

United States equity markets surged ahead in November as the prospect of a Trump presidency held the promise of increased spending in the economy. Soon enough, investors started questioning where the money would come from – especially in a climate in which the national debt has inflated to historic highs. Furthermore, one of the nation’s major creditors, China, started to trim its holdings of US Treasury bills and bonds. In December we saw some of this tension as day after day market commentators asked if that was the day the Dow Jones index would push through the 20,000 level. By the end of December, however, the Dow had not managed to breach that psychological barrier. In order to address the question of whether a nation can afford to spend more given already high debt levels we need to revert to some basic economic concepts. Spending in an economy is essentially comprised of existing money and credit. Credit is transformed into debt when a borrower enters into an agreement with a creditor. Credit is thus a function of the desire of borrowers to spend today understanding that there will be a time in the future that they will need to spend less because those future earnings have already been committed to repaying the debt incurred today. Borrowers will usually assume a debt because they aim to increase their living standards today, rather than wait for slow moving productivity gains to lift their income levels. Credit in essence acts like an option on future productivity growth, and in the context of the past few weeks, investors seem to believe that Trump’s policies will stimulate economic growth through private investment. A good proxy for private investment is gross fixed capital formation or simply private capital formation.

The most recent breakdown of US GDP growth reflects a dominance of consumption spending with a low proportion of overall GDP taken up by private capital formation. That disproportionate balance makes it harder to improve on and sustain productivity growth in the long term. In our previous comment we have argued that South African government spending has not sufficiently grasped the importance of investing in productive capacity, and despite the Trump rhetoric of investing in infrastructure, his determination to cut taxes on the wealthy has drawn into question his commitment to sustainably fund US infrastructure development. His policy ideas are reminiscent of trickle-down economics, an experiment in the 1980’s that was sufficiently disappointing that no serious economist advocates it by name any longer. This is all to say that like all politicians, Donald Trump has to be watched carefully and his choices evaluated objectively. Although social media has helped to build awareness and interest in plebiscites, the election of Trump has shown that that awareness has not always translated into a higher voter turnout nor the widely anticipated result. Nor did Brexit show that a relatively high turnout would result in a ‘Remain’ vote. It is in that context that we assessed the Italian referendum in early December a risk to markets. What was it about the Italian referendum that was so interesting? Most observers pronounced that it would affect the stability of a Europe in the process of recovery, and ultimately that a disintegrating European Union would derail the global economy. It turns out that the average Italian was not that fussed about the continental or global picture. The reforms proposed by former Prime Minister, Matteo Renzi, would have taken some power away from an entitled and advantaged Senate but that was not enough for an Italian electorate that has long resented privileged parliamentarians. The big issue that most missed was that the Renzi Reforms included proposals to restructure the Italian banking sector that would have wiped out lots of bank equity. The referendum required individual voters to vote against their own strained pockets as the troubled banks’ shares are held by many domestic retail investors, and those retail accounts would have preferred easier bailout terms from the ECB in Frankfurt. Additionally, pension investments would have been affected so in that sense the opposition’s political message of ordinary investors being unfairly punished was always going to resonate with the electorate. Italy – and Brexit and the US election before it – have taught us not to underestimate perceived benefits at a micro scale. The second lesson that Italy taught us is that not all looming events are of equal significance; the markets hardly moved on the Italian result.

In mid-December the leaders of the EU’s Parliament, Council, and Commission made a joint declaration of their priorities for 2017. It was the first such joint declaration and two out of the six main points (a third) were linked to the idea of securing European borders. Forget about the euro and fiscal consolidation for now; in the foreground is migration, European civilisation and the refugee crisis. It is the future of the social fabric that is in focus and we all understand at least vaguely that it is a concern that is not limited to Europe. Americans have already voted in that direction and the sense one gets is that political elites feel that they are getting squeezed against their consciences to engage with Russia simply because for nationalists Russia now represents a swaggering ideal. An ascendant Russia turns conventional politics on its head. The US had previously invested in its China relationship while chiding Russia. Europe did the same. Now Trump seems to be enabling the ascent of Russia to the concern of the Chinese government and the European old guard. As an EU member, the United Kingdom has frequently had to scramble jets to intercept Russian aerial sorties but as it exits Europe will it join an emerging US-Russian axis under Trump? Will an ascendant Russia increase its actions in support of the regime in Syria because Trump is happy to see ISIS and its ilk stamped out by the Russians who also want stanch support for Islamic extremism in the Caucasus? Ultimately, could such action increase refugee flows to Europe and is Europe better prepared for a further wave of refugees? It is not only the European Union that will have to form clear impressions about the answers to these questions. Britain faces the known challenges of defining its future trading relationship to the Bloc and to other countries around the world. What is less prominently understood is that the UK will have to go through a process of setting baselines as a standalone member of the World Trade Organization. A collection of baselines is known as a schedule and it speaks to market access commitments agreed, such as tariffs and subsidies. The new schedule has to be agreed unanimously with the WTO’s members. The UK ideal is for a document that looks like the EU one; however, it is suspected that countries that have had territorial disputes with the UK such as Spain and Argentina will use the WTO baseline negotiations as an opportunity to force uncomfortable compromises in those disputes. Thus, whatever concessions the UK gets on access to the European Single Market, it still has to contend with minnows interested in exacting revenge.

Since staging a strong recovery in 2010 and 2011, South African GDP has reflected a progressively slower rate of growth. Consensus expectations for GDP growth for the coming year are around 1.1 percent, having come down during the course of this year alone from about 2 percent. Even if realized GDP growth is 1.1 percent it will remain below the 10-year average GDP growth rate of 2.2 percent, the 5-year average GDP growth rate of 1.6 percent and even the 3-year average GDP growth rate of 1.2 percent. Consistent with the weakness in the GDP growth profile, the VFM Composite Indicator remains at subdued levels. If the rand continues to hold firm versus GBP, at 14 or better versus USD and at 15 or better versus EUR, then our exports are less interesting to our trading partners. That could be something of a headwind for economic output.

Observers of the domestic market often expect a one-for-one reaction in the local markets to what happens offshore. The financial press tends to mislead us through the habit of explaining every movement in local indices or the currency against the backdrop of a foreign event. In fact, on deeper analysis our local equity market currently reflects a pretty muted correlation to foreign markets. Measured against most major equity markets, the South African equity market in most cases has a realised positive correlation of about 33%. It is thus reasonable to expect that as de-globalization gets under way due to regressive moves on trade agreements by Trump et. al, these correlations will reduce even further.

Implications for investment markets in 2017

The world sees the reflation trade as obvious. But with trade disputes, Brexit and limited scope for fiscal stimulus looming is this obvious, OR is the world still caught in a deflationary trap where China continues to export deflation via a weaker currency, surplus capacity persists in commodity markets and capital is slow to invest? The net effect of this scenario is a much slow rate of appreciation of the dollar than expected leading to a moment when the market realises that it’s not Trumps first pitch but rather a loaded base resulting in further downward revisions to earnings and a reversal of the Trump dividend.

Against this background investment focus in 2017 could well favour the non-consensus trades. Hold more long duration domestic bonds for both yield and low levels of prospective inflation, lock in high short term yields in the domestic market through NCD’s, expect the rand to stay firmer for longer. Commodity stocks unlikely to provide leveraged returns as the “reflation trade” fades a little.


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.