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Q3 2017 – Economic Commentary

Investment mandates are constructed with a traditional risk spectrum in mind that places government-issued or government-guaranteed debt at the least risky end of that spectrum after cash. The past several months since the March Cabinet reshuffle in South Africa have essentially challenged investors to invest in a framework where there is diminishing assurance that government debt is the least risky asset that could be in a portfolio.

Budgeted revenue growth has stalled to an annualised pace of about 3.4 percent while the Budget was built around a 9.4 percent figure. Meanwhile, State-Owned Entities such as South African Airways and the South African Broadcasting Corporation have come calling for billions in emergency support. The government’s contingency reserve is depleted, and institutional bond investors are nervous about the State’s credit rating and the trajectory of its budget deficit. Those are the concerns expressed in the press, yet in the markets the price action suggests something else.

The local nominal bond market traded with a firmer bias for much of September before encountering some volatility in the final week. Nevertheless, the All Bond Index still returned close to 1.1 percent for the month and nearly 3.7 percent for the quarter. Some of the explanation for this positive tone seems to be a continuation of approximately USD 19.2 billion in flows into emerging market debt this year. This is turn has been made attractive by slowing inflation in emerging markets, and in South Africa in particular. This has opened up scope for policy rate cuts. That in turn is good for bond prices.

An additional factor bolstering the inflation story is a US dollar that has been somewhat weak. All the world’s major currencies including the South African rand have had positive total returns relative to the US dollar in the year-to-date.

The upward move in the local bond market is consistent if one thinks of emerging markets exposure as whole, as a “risk-on” move. Despite a negative September for the All Share Index, equities are still up about 12.6 percent in the year-to-date, and a healthy 8.9 percent over the most recent quarter. The key appears to have been to look at South African risk assets as a global investor might, eschewing the poor visibility that a domestic investor might have. Apart from a brief spike in zero-volatility spreads* at the time of the end of March Cabinet reshuffle, the Z-spread has bit-by-bit tightened to almost the year’s lows. In other words, foreign investors continue to look past the risks that preoccupy us, whether they are ratings downgrades or political party elective conferences.

A different way to look at the various asset classes is that they are all receiving net cash. US equities were up last month, in the year-to-date, and in almost all standard periods in between. US equity markets have not suffered a single monthly loss this year so far. A broad market investment in South African equities at the beginning of the year is comfortably in the green.

The big picture question for all investors is: when does it end? A US 10-year bond trading closer to 2 percent is quite a turn from talk early in the year of 3 percent by the end of 2017, or from the wildly mistaken belief of a few years ago in “normalisation of the yield curve”. The market is no longer appears to believe that normalisation of the global yield curve will be an imminent event, despite what we hear in the news. One needs to be careful to not underestimate the amount of liquidity remaining in the financial system. Our sense is that the final quarter of this year will be positive for risk assets overall.

While inflation is subdued in South Africa and not very firm elsewhere, we think that the economic growth outlook around the world continues to be positive. In the first few days of September we got an initial reading on South African 2Q GDP growth. After a first quarter negative reading the economy registered a positive 2.5 percent figure. The finance minister was quick to point to it as proof that the economy was on the mend. Economists were less upbeat, pointing out that it largely reflected the effects of a low base. Nonetheless, we do not expect further quarters of negative growth over the coming year. Our greatest concern in South Africa is that the growth that we do expect to see will be tepid.

Economies can be split into roughly three macro segments: the primary sector, the secondary sector and the tertiary sector. In South Africa, the primary sector accounts for nearly 10 percent of the economy, and includes activities such as agriculture and mining production. The secondary sector accounts for about 18 percent of the economy, and includes activities such as manufacturing, mining beneficiation and construction. The tertiary sector is the rest, totalling close to 63 percent. It includes services, transport and communication among other activities. These three cogs are neatly interlinked, for example, with a turn in construction (secondary sector) able to drive a turn in tertiary sector activities such as transport.

In the 2Q2017 GDP numbers we saw a seasonal component, namely agriculture, drive the biggest share of the gain. In other words, the gain was driven by (a) a component of the smallest of the three economic segments, (b) a seasonal component, and (c) a component whose strength might be at risk because of drought.

Looking ahead and to the biggest segment of GDP, the weakness of private sector investment remains a concern especially as industrial capacity withers, lowering potential GDP. The SARB estimates potential output at 1.5 percent, leaving little space for the economy to accelerate before overheating. At the same time, in its models the SARB has historically used a neutral rate estimate of around 3 percent which in current times has probably moved closer to 2 percent. Understanding that the neutral rate is connected to an equilibrium inflation rate, we are able to introduce an economics concept known as the sacrifice ratio. It is the demand (and then output) reduction necessary to see the inflation rate move down by one percent. The sacrifice ratio arises too when an economy can sustain only a lower level of inflation. In effect, the lack of inflation-bearing capacity in South Africa means there is an opportunity cost. Thus, the inflation-bearing capacity of the economy is judged to have been compromised while the likes of S&P Global Ratings and Moody’s are looking for growth rates of 3 percent and upwards to alleviate their concerns of a growth trajectory sufficient to fund income redistribution.

There are few signs that sectors strongly allied to capacity build are doing well. Construction contracted in the second quarter as it had in the first quarter. The most significant client of the sector – government – is under pressure to stay the course on fiscal consolidation. Government is doubly under pressure owing to tax revenue underperformance. As far as behaviour goes, in periods of fiscal consolidation government tends to “save” by delaying things like infrastructure spending but current spending is left relatively untouched.

In mid-September the Current Account data for South Africa were released. The deficit widened to 2.4 percent in the second quarter as compared to 2.0 percent in the first quarter. The same period in 2016 produced a deficit of 2.6 percent. What is interesting in the 2Q2017 numbers is that as with the first quarter, merchandise exports were nearly neatly matched in value by merchandise imports. In absolute terms these are by far the biggest figures in the flows, and for the purposes of thinking about demand and supply it helps to ignore current transfers which include things like dividends to offshore shareholders. After a notable drop in 3Q2016, these figures have steadily recovered back up to their 2Q2016 levels, and in a sense they point to a gentle revival in merchandising demand and supply in the economy.

We still have to be cautious about implying that final consumer confidence and spending is in better shape because activity data from StatsSA for the start of 3Q2017 show some slowing in retail sales growth. Furthermore, we have an odd situation where fixed capital formation was negative in the quarter but the current account also became a bit more negative.

What we usually expect is that a wider current account deficit reflects higher imports such as machinery that goes into projects to build capacity. If this is not the case, we might conclude that savings are being depleted either by simple transfers out or by consumption. Neither of those would be good for sustainable growth over the longer term.

*Zero-volatility spread (Z-spread) is the constant spread that makes the price of a security equal to the present value of its cash flows when added to the yield at each point on the spot rate Treasury curve where a cash flow is received. In other words, each cash flow is discounted at the appropriate Treasury spot rate plus the Z-Spread. The Z-spread is also known as a static spread. 

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

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