The global economy ended the year in its best shape in a decade. The biggest developed economies, the Eurozone, US and Japan, posted annual growth rates of 2.7%, 2.3%, and 2.1% respectively in the third quarter.
China grew 6.8% in the fourth quarter which means that economic growth in 2017 as a whole was faster than in the previous two years. This was despite widespread expectations that China’s economy would slow down after attempts by authorities to pull back on rampant credit growth.
Global equity markets also ended last year on a high and this momentum generally carried over into the first weeks of January. December was a positive month as analysts upgraded earnings expectations amid improving economic growth and a cut in the US corporate tax rate from 35% to 21%. Developed market equities posted a 23% return in 2017, and emerging markets 37% in US dollars. Most of this was due to improved earnings growth.
Rising rates but falling dollar
Despite rising short and long-term interest rates in the US (the Federal Reserve hiked rates in December for the fifth time in this cycle), the dollar weakened rather than strengthened. As other major economies have caught up with the US in terms of growth rates, their central banks are expected to reduce monetary stimulus.
The weaker dollar, narrower spreads on corporate bonds relative to government bonds and high equity prices (and therefore cheap equity funding) mean that financial conditions in the US have eased even though the Fed has hiked and trimmed its balance sheet. In other words, the broader economy and markets are not being starved of liquidity.
The combination of a weaker US dollar and stronger global growth has supported commodity prices. Oil is the most obvious example, helped along by a bitterly cold Northern winter, supply disruptions in the North Sea and jitters over Iran. But other commodities have also benefited.
Political uncertainty easing
Locally, the big event was of course the ANC’s elective conference at Nasrec. The rand surged as a Cyril Ramaphosa victory became likely. This might be overdone, firstly because markets tend to overreact both on the way up and the way down, but also because much uncertainty remains.
There are still “two centres of power” running the country – one in the Union Buildings, and one at the ANC’s headquarters at Luthuli House, limiting the scope for reform (though developments over the weekend suggest this conflict could be resolved soon).
Ramaphosa has made all the right noises in terms of focusing on economic growth, investor confidence, combatting corruption and fixing state-owned enterprises. The latter is crucial, because although Eskom is no longer crippling the economy with rolling blackouts, it risks doing so with its debt burden. The appointment of a credible new Board is therefore very welcome.
Nonetheless the 11% rand rally against the dollar since the start of December gives an idea of the kind of risk premium foreign investors attach to South Africa because of political uncertainty. The potential clearly exists for a significant bounce in confidence over the short term.
We need confidence
Improved confidence is the cheapest form of economic stimulus. It is even more crucial given that fiscal policy is likely to tighten further this year. Government needs to stop the unsustainable growth in its debt level, but tax revenues have grown disapprovingly slowly.
At the same time, the ability to cut spending is limited and the announcement of free higher education for low-income students just adds to the long list of spending needs. Tax rate increases are therefore likely, possibly even an increase in the VAT rate.
If the economy surprises on the upside – if we also have a virtuous cycle of sentiment, growth and investment, all of which are low and with plenty of room for improvement – tax revenue collection should also improve and limit the need for tax rate hikes. This is the tricky balancing act the Minister of Finance (whoever he or she will be in February) will have to follow: hike taxes too much and you might hurt the economy and end up getting even less tax revenue.
Moody’s, the last ratings agency that rated South Africa as investment grade, will review its decision after the Budget Speech. It wants to see fiscal consolidation (smaller deficits) and growth enhancing reforms. A downgrade means that government bonds would no longer be included in the Citigroup World Government Bond Index. Foreign investors who track this index would then be forced to sell out, although most foreign investors probably don’t.
In terms of monetary policy, some stimulus is possible thanks to the stronger rand. The Monetary Policy Committee (MPC) of the Reserve Bank left the repo rate unchanged last week, despite an improved inflation outlook.
The MPC still fears that a Moody’s downgrade could cause a spike in the rand, while the other perennial concern is the Fed’s rate hikes (but as discussed earlier, the dollar has weakened recently despite higher US rates). Finally, the recent surge in the oil price is also on its radar screen, even though the stronger rand means that a petrol price cut is likely next month.
The Reserve Bank cut its inflation outlook for this year from 5.2% to 4.9%, but its core inflation forecast for 2018, excluding oil and food prices, is substantially lower at 4.6% from the November estimate of 5.1%.
These projections are made using an exchange rate assumption of ZAR12.90 per dollar, although it is currently around 5% stronger. Persistent rand strength will lead to further reductions in the forecasts, and once we’re past the Budget Speech and Moody’s reaction to it, potentially a rate cut in March or May 2018.
However, embedded in the Reserve Bank’s forecast is a neutral real interest rate (the rate that is neither stimulative nor contractionary) of 1.8% this year rising to 2.2% by 2019. This is remarkably high given that recent estimates of the US neutral real rate (called r* by economics nerds) is around 0%.
We don’t know for sure, because it is a theoretical construct, not something that can be observed. But it does mean that the South African Reserve Bank (SARB) thinks South Africa needs much higher real rates than developed markets as a buffer against destabilising capital outflows.
The Reserve Bank raised its growth forecast slightly (and this forecast assumes no further rate cuts; instead it assumes a few rate hikes). It reckons 2017 growth was 0.9% instead of 0.7%, the final numbers are not out yet) and that 2018 will see growth of 1.4% rather than 1.2%.
While the political outlook is uncertain, it is much less so than only a few months ago, which should lift business and consumer confidence. This would reinforce the modest improvement that was already in place late last year. The jump in real retail sales growth to 8% year-on-year in November can partly be ascribed to “Black Friday” becoming a bigger shopping event, but underlying it is faster growth in real incomes as inflation has subsided.
What are the investment implications of the above? At the start of 2018 the global backdrop continues to appear supportive for equities. The local market follows what happens globally, but some domestically-focused sectors could outperform if the local economy picks up steam. With a conservative central bank, a benign inflation outlook and high rates, domestic fixed interest remains attractive.
Further potential downgrades don’t negate this view (but might introduce short-term volatility). Global bonds remain unattractive as interest rates gradually return to more normal levels in the developed world. Finally, though the rand strengthened sharply late last year, its current level is more or less fair and therefore does not strongly argue for a major change in international exposure.
Dave Mohr, Chief Investment Strategist and Izak Odendaal, Investment Strategist, Old Mutual Multi-Managers