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Inversion, submersion and dispersion

The health of the global economy is concerning.

Global equity markets enjoyed a temporary bounce last week when the US government said it would postpone the imposition of tariffs on some Chinese goods, while some items would not be taxed at all. President Trump initially planned to impose 10% tariffs on $300 billion Chinese imports at the start of next month. It does show that the Trump administration is worried about the impact of tariffs on the US economy, and wants to avoid prices on consumer items jumping ahead of the Christmas shopping season. However, this was soon overtaken by renewed concerns over the health of the global economy.

Submersion

New data showed that Germany’s economy contracted in the second quarter, which is no surprise since it is heavily dependent on exports, particularly in the struggling automotive industry. It is also exposed to China, where July data showed the economy slowing more than expected, and to the UK, plagued with Brexit uncertainty. The entire German yield curve is now submerged below zero, screaming for the tight-fisted German government to borrow more and spend more. But the country’s leaders remain committed to the schwarze Null (black zero) of a balanced budget. In ordinary times, that might be commendable, but these are clearly not such times.

Chart 1: 30-year government bond yields, local currency %

Source: Refinitiv Datastream

Inversion aversion

Global weakness saw a rush into the perceived safety of bonds, with the US 30-year bond yields falling below 2% for the first time. In other words, the market expects interest rates to be below 2% for the next three decades, an extreme outcome. More ominously, 10-year bond yields dipped below two-year yields for the first time since 2007. This spooked the equity market as the so-called inversion of the yield curve has preceded past recessions.

Essentially, it means that the market expects the future to be worse than the present.  It is important to note that the inverted yield curve does not cause a recession (unless it scares ordinary Americans to stay at home and stop shopping). Rather, it reflects the bond market’s expectations of near-term growth, inflation and interest rates versus longer-term expectations. The near-term expectations are anchored on the policy stance of the Federal Reserve (the Fed), so that the market is effectively saying the Fed’s rates are too high now and it will be forced to cut rates. 

Chart 2: The spread between 10-year and 2-year US government bond yields %

Source: Refinitiv Datastream

This creates a dilemma: on the one hand, you shouldn’t ignore the bond market, and the most dangerous words in finance are said to be “this time is different”. On the other hand, this time might really be different. No other tried-and-tested recession indicator is flashing red, and the collapse in bond yields in Europe and elsewhere must surely play a role in dragging US yields down. These, after all, are now the highest yields in the developed world. Canada, Australia, Britain and even politically-unstable and highly indebted Italy have lower yields than the US. This also reflects the relative strength of the US economy.

All the latest reports on the US economy show healthy levels of consumer spending, supported by a strong job market, low inflation and low interest rates. The US manufacturing sector, along with those in other major countries, is struggling. Despite President Trump’s efforts, the trade wars seem to have hurt rather than helped US manufacturers in total (though some will have benefited). But this is a small part of the services-driven US economy. The trade wars are also causing pain in other countries, notably China, where industrial production growth in June was the slowest in decades (but still strongly positive).

Cutting in droves

Central banks are of course already cutting rates in droves, with Mexico the latest major economy to do so. The US Fed is likely to follow suit at its September meeting. The market will want to see not only a cut from the Fed, but the guidance that future cuts would also happen. These rate cuts will not do much to stimulate new borrowing since global debt levels are already so high, but will ease the pressure on existing borrowers. Importantly, central banks will act to prevent a repeat of 2008 when market stress impacted the real economy as credit channels seized up.  

How will the SA Reserve Bank respond? It has already cut rates once, but this was just reversing November’s hike. The recent sell-off in the rand might preclude it from cutting at its next meeting, but oil prices have also pulled back. The Reserve Bank will also be viewing the deteriorating fiscal position with some alarm. However, in the current context, the widening budget deficit is not inflationary, since it is bailing out Eskom, not stimulating domestic spending. Ultimately, the Reserve Bank is likely to follow other central banks and lower rates.

Dispersion

This is because, in the global dispersion of real interest rates, South Africa is now close to the one extreme, with Germany at the other. As global fixed income yields plummet, South Africa has gone in the other direction. Foreign investors have pulled money out of the local bond market, worried that government borrowing will rise dramatically to fund Eskom. The tabling of a draft National Health Insurance (NHI) bill has not helped sentiment either. While it has noble objectives, it would entail potentially hundreds of billions in additional annual outlays upon planned final implementation in 2026. (The estimated costs and funding mechanism have not yet been announced.) With markets already questioning South Africa’s fiscal management, the timing was not great. Realistically though, it is hard to see how such a complex restructuring of such a large and important sector can be achieved in seven years, and a more piecemeal approach seems likely.

But a lot of the pessimism is surely overdone. While government debt is rising due to Eskom and weak tax revenue growth, the government is far from bankrupt. The increased talk of South Africa turning to the International Monetary Fund (IMF) for assistance is also misplaced. The IMF itself sees no reason why we can’t sort out our own problems without its help. It has noted that the asset side of the government’s balance sheet is larger than the liability side, but the assets need to be ‘sweated’, or sold, to deliver a decent social or economic return. The IMF helps countries that run out of dollars to repay debt or fund imports, usually when capital flows dry up. South Africa’s government debt is mostly rand-denominated and there is no sign that it is struggling to fund itself in the local bond market. The flexible exchange rate takes care of the rest. South Africa is not Argentina, dependent on borrowing abroad in dollars.

Argentina turned to the IMF last year (for the biggest bailout on record) precisely because the lack of a domestic bond market means the government borrows in dollars. However, last week its financial markets suffered a sharp collapse – currency, equities and bonds slumped between 30% and 40% overnight – after the reformist President Macri lost a key indicative vote ahead of October’s presidential elections. Much like President Ramaphosa, Macri tried to clean up a huge mess left by his predecessor. However, the medicine he prescribed was too bitter for the people of Argentina, but not bitter enough from the point of view of the markets, who have been fleeing Argentinian assets for the past 18 months. Now it appears Macri is on his way out, to be replaced by a populist who investors fear will make things worse, while promising to make things better.

The JSE is not the economy

It is easy to connect the dots between all this local political and economic uncertainty and the continued poor performance of the JSE, but this connection is overstated. In fact, the JSE has been hit by a perfect storm of events, and virtually everything that could go wrong seems to have done so in the past three years. The JSE has also performed in line with other non-US stock markets over the past three years and longer, a period where only US equities have performed really well (see chart 3). There is no question that the weak economy has hit domestically orientated shares, and the NHI bill is another example of policy uncertainty weighing on share prices (this time of medical insurers). But more than half of the earnings of JSE-listed companies is generated outside South Africa. The global presence of local companies has also increased over the past few years, with Reserve Bank data showing that domestic companies invested almost R500 billion abroad over the past seven years, but without much to show for it. There are several examples of poor offshore acquisitions, with Woolworths, Truworths and Famous Brands standing out.

Crucially, JSE exposure to the high-flying US market is low, while exposure to the UK is relatively high. Overall, the global exposure of the JSE is concentrated, and subject to company-specific issues. For instance, Sasol’s problems caused another sharp pull-back in its share price last week. Last year it was the 40% decline in British American Tobacco and 20% decline in Richemont. All three are big components of the local benchmark. This year, only Naspers and mining companies have performed well, the latter can still largely be viewed as a recovery from the pre-2016 rout in commodity prices, with the weak rand also helping.

Chart 3: The JSE and other major equity indices over the past decade in US dollars

Source: Refinitiv

Usually, an equity market sell-off is accompanied by a decline in interest rates, so that shares become more attractive and fixed income less. This has happened globally, but not locally. In fact, high rates are just one of the reasons why local equities have struggled. Both short and long-term fixed income yields stand out like a sore thumb in the international context and offer very attractive real returns. However, the risk remains that in viewing the poor performance of the JSE as a South Africa-specific story, investors become so mired in pessimism that they assume it can never recover. Domestic shares already price in a very gloomy medium-term outlook for the South African economy and can positively surprise on any evidence of a slightly improved outlook and a rebound on global equity markets.

Dave Mohr is chief investment strategist and Izak Odendaal an investment strategist at Old Mutual Multi-Managers.

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The South African government is not bankrupt.

Yet.

Unless some really radical and hard measures are taken, such as firing half of Eskom’s wêkkas, it will be soon. Would the authors above be willing to take a wager with their own money that this will happen before SA’s debt is out of control?

Our relatively high bond yields act as a deflation magnet. Our economy is the victim of the deflationary spiral that originates from the developed nations. In effect, by lowering their interest rates, those developed nations “export” their deflation to countries who have higher interest rates. Local businesses suffer under relatively high interest rates as there margins and there ability to compete is squeezed out.

There is a currency war raging on the international arena, and we are the losers. We are the deflation dump yard for the major Reserve Banks of the world.

If we lower interest rates the Rand will weaken to cause a loss of purchasing power, if we keep interested rates stable, the JSE will weaken, leading to a loss of purchasing power. This is checkmate.

Weakening the Rand will be good, if we still had a mining sector to shoot the lights out.. They might even employ some people again..

Hi Sensei. Can you please explain for the non-economist like myself how exactly this exporting of deflation works? I am trying to understand it logically what happens. Would appreciate it. Thank you.

Deflation is a process of declining prices because the supply of goods is higher than the demand. This is normally the result of a contraction in the money supply or a decrease in credit extension. When the factors that drive inflation are reversed, we experience deflation. Deflation is toxic to the banking sector because it destroys the value of their collateral while the size of the loans stays the same.

By lowering interest rates, Reserve Banks also make their bonds less attractive. Fewer people buy bonds. This leads to a weakening of the currency. The combination of a weaker currency and lower interest rates improves the ability of the businesses to compete. Competing products that are imported become more expensive and exports are more profitable. This situation supports the business environment in general. This fight for profitability and need to protect their economies and specifically, their banking system, motivates countries to participate in the international currency war.

As a result of the deflationary spiral on the international markets, countries are competing to have the lowest interest rates and the weakest currencies. When Trump threatened China with tariff increases, China reacted by lowering its currency.

In South Africa, we have relatively high interest rates because we need to entice international investors to lend money to our government. The relatively high interest rates keep our currency relatively strong. The combination of high interest rates and a strong currency kills the ability of our industries to compete in the international arena. The competition from cheap imports and the lower value of exports squeezes the profit margins of local manufacturers and farmers.

So, in effect, when South Africa keeps its interest rates relatively high compared to our competitors, we attract the deflation problem that other countries are trying to manage, to our shores. We import the deflation, or we act as a deflation magnet.

I hope this explanation clarified the issue. ☺

Exponential economic growth on a finite planet. Impossible.

Global overshoot of any resource you care to name (okay, so not cheap labour and plastic in the oceans). Unsustainable everything.

Burning through oil reserves at 10 times the replacement rate. A theoretical 50 years of oil left, but practically no more than 20. The end of oil, make no mistake, is also the end of the entire industrial age as well as globilisation. Brexit and trade wars are just the start.

A world of 7,5bn people headed for 11bn; and a world of unprecedented complexity with more on the way.

These 7,5bn have arrived on earth, not during the climate of the jurrasic, or the younger dryas – they arrived in the climate of the last century. And the climate of the last century is what we are busy changing out of all recognition.

The world is in its biggest ever debt bubble created to preserve the illusion of continued economic growth, and about to go on another exponential increase. To be followed by even more until possible hyperinflation everywhere.

Do the math. There are no good times ahead. We are not heading for the good old days.

So what we are now experiencing are the emergent cracks in the system, and the dawn of new false hopes ( if only we ate less meat! What if we turned the Sahara into a big solar farm? ….The list is pretty endless).

So nothing in this article is actually surprising. What is surprising is the inability of the mainstream to join any of the obvious dots.

It isn’t inability to join the dots. It is unwillingness to join the masses together by connecting the dots for them. Divide and conquer. Misinformation is abundant for this very reason.
Loved your post. Absolutely well said!

The problem for SA Inc is the fact that we have a government who will always make the wrong decision – exactly like what happened in Zimbabwe, Argentina, Brazil, etc. Go and look at any country that has been bailed out by the IMF and you will see the exact same socialist/populist trend that lead to the bail out. You can parade any statistic you want, but statistics mean nothing when we insist on doing the wrong things. We might not currently need the IMF to bail us out, but we do need the IMF to force us into making the right decisions before we join the very long list of delinquents. This, for me, is where the frustration lies: we know we are going down the wrong path, but we refuse to do the right thing.

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