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Home / Investment Insights / Q4 2017 – Economic Commentary

Q4 2017 – Economic Commentary

One of the most crowded trades by South African investors this year has been to send money offshore. It was inspired by at least two factors and possibly more. The first was an expectation of a more robust global economy,led by gains in the United States as well as Europe. The second was pessimism about the local political and fiscal situation. Investors who continued to commit money to that trade at the end of November have been quite disappointed by the end of December. While broad offshore equity indices largely delivered positive returns in their local currencies, the strength of the rand has meant that rand-based investors have experienced negative returns in the region of minus 5 to minus 11 percent.

In addition to robust American stock returns, blame the hype about promised US tax cuts for luring South African investors offshore. The theory is simple enough: lower taxes should result in higher profitability and higher share valuations. In practice, we have found that tax burdens are not strongly correlated with stock market returns. Resolving this conundrum may, in part, lie in data produced by the Congressional Budget Office and by the Tax Policy Center in the US. Their analysis suggests that through to 2025, the average annual increase in growth linked to the Republican tax bill is around half a percent. This is almost always offset by the cost associated with the anticipated increase in the budget deficit which is almost always greater than the anticipated growth. The net result is that, as a percentage of GDP, the proposed US tax reform could well be negative for the US economy, an outcome that does not square well with the hopes of equity investors.

These risks aside, the US economy, over the first three-quarters of the year delivered real GDP growth at an average annualised rate of 2.5 percent. The annualised growth rate is expected to slow slightly in 2018 and even further to about 1.75 percent in 2019 despite the likely passage of the reconciled tax legislation. According to the San Francisco Federal Reserve, interest rate hikes are expected to combine with slower productivity growth and demographic ageing to offset the positive expected tax effect.

Despite the slower growth trajectory, large institutional investors continue to predict three and perhaps four interest rate hikes from the US Fed in 2018. The San Francisco Fed famously suggested in November that inflation has been subdued below the 2 percent target in significant part because of the declining costs of medical care. In their December outlook, they point out that they expect the effects of slow price growth in healthcare and telecommunications services to be non-permanent, perhaps granting space for an acceleration in American inflation by as soon as 2018.

Implied probabilities currently suggest a 98 percent chance that the FOMC will leave the US Federal Funds rate unchanged in a range of between 1.25 and 1.5 percent during 2018. It remains to be seen how Jerome Powell’s leadership of the committee will alter the sensitivity of the FOMC to inflation dynamics, but ahead of his assumption of the chairman’s role, there is little expectation of a material shift. Although index duration extensions have led to flattening pressure on the US yield curve as the long end has been in higher demand than the short end, large institutional investors expect to be positioning themselves for three hikes with a short duration stance. The rationale cited is that with bond prices so rich it only takes a minor news disappointment to knock long bond prices and so safety is to be found in the short end, notwithstanding the expected hikes. Overall, the large institutions expect some curve steepening accompanied by more volatility than we have seen over the past year with this caution extending in reducing exposure to high yield credit. Interestingly enough, because there is no assurance that inflation will accelerate materially in both the US and Europe, developed market interest rates could remain lower for longer. In consequence, these large managers are not yet ready to give up their positions in emerging market local currency bonds where the yields are high and can be hedged back into US dollars if so desired.

Fortunately for South Africa, the country’s bond market continues to offer relatively high nominal yields. Unfortunately though, is that it is not part of a coterie of countries that could receive investor attention as a result of the possibility of a credit upgrade. We have seen instances where bond markets perform better after credit downgrades, nevertheless, the common narrative is that countries primed for credit upgrades are to be preferred.

Towards the end of November South Africa’s local currency debt was downgraded to sub-investment grade at S&P Global Ratings. With two out of the three key rating agencies pegging South Africa’s local debt below investment grade, 5-year credit default swap spreads continued to compress from about 180 to below 160 points in December. The rand against the US dollar strengthened too from about 14-and-a-half to around 12.30, seemingly ignoring local investor anxiety about what was expected to be a bruising contest for the leadership of the ANC. With a number of peaks and troughs along the way, the rand-dollar exchange rate was better by the end of December than at both the beginning of December and the beginning of the year.

It is tempting to suggest that the local anxiety about the transition of power in the governing party was a storm in a teacup as far as markets are concerned – the truth is more complex. With leadership comes the responsibility of guiding fiscal priorities. The very real concern within the context of the current political dynamics is that capital misallocation that arises from fiscal mismanagement has dire longer-term consequences. It is apt to remind readers that while investors, by and large, got the candidate they preferred, their war is not won. A little history lesson might be helpful here: the War of the Eight Princes does not refer to a single war but rather an expanding series of conflicts between the years 291 and 306 in Jin dynasty China. Central to these conflicts was the question of regency as the result of the developmental disability of the Emperor, Hui. By the time the Prince of Donghai emerged as the eventual victor, his victory was a Phyrric one; the devastation caused by the War weakened the Western Jin to such an extent that they were eventually overtaken by the Wu Hu. With that in mind, investors and the public at large will have to avoid the temptation to see tightening CDS spreads or a firmer currency as proof that all is well. Investors and the public will have to remain vigilant in analysing the economic choices that the country’s executive pursues from this point forward.

While holding rands was better than holding dollars during the complete year, holding rands was worse than holding almost any other major currency. On carry returns the rand outperformed the Swiss franc, the Japanese yen and the US dollar; all low-yielding funding currencies. A short rand, long Mexican peso trade was the best trade of 2017 among the major currencies. Short rand, long euro was the next best, and even short rand long any Scandinavian currency returned a positive carry. The US dollar index has been on a weak and weaker trajectory throughout the year, benefiting US net export growth while having a muted impact on US inflation because import pass-through inflation is not as significant a factor in the US as it is in South Africa. With that in mind, as 2017 ends it is useful to reiterate some economic priorities that make sense in South Africa: less volatile inflation, a less susceptible currency, better export growth, better domestic growth, a rebalancing in government between current and investment expenditure, and improved government debt management. These and the commitment to combat lawlessness will be important to re-establishing to rates of growth sufficient to sustain the poverty alleviation and redistribution strategy that the government declares as its aim.

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.