Sanlam Select Strategic Income comment - Mar 19
While we continue to look for a slow, bumpy economic recovery, early-year drawbacks (loadshedding and broader SOE support) have somewhat taken the shine off the shortterm outlook. South Africa's current economic profile stands out by ranking with countries at war and in political turmoil (think Venezuela and Argentina). Following six years of stagnant GDP per capita, electrical shortages, weak confidence and risks to the global outlook, further downside pressures persist. We will not be surprised to see a negative GDP growth print in 1Q19, and with the second quarter unlikely to see a sharp recovery, the burden on post-election 2H19 to drag GDP over the 1% mark now becomes quite onerous. From our initial expectation of 1.0-1.3% growth, growth will probably print below this forecast.
Clearly South Africa is currently ill-equipped to deal with a recession.
This highlights the importance of post-election reform to raise trend growth and break the negative cycle.
The fiscus remains under pressure. Unjustified ongoing socialist ideological support to SOEs that are caught in a death spiral, regressive tax policies pushing us past the peak in the Laffer Curve, and a collapse in business and consumer confidence, paint a bleak picture. It is very disappointing that funds extended to SOEs aren't done so contingent on them meeting strict publicly available pre-determined targets.
Funding needs of health schemes, free education, crumbling infrastructure, a bloated ? and highly overpaid ? public sector workforce all pose risks to fiscal consolidation and debt stabilisation. South Africa is now also deviating from its own expenditure ceiling.
The continued reliance on short-term financing flows to fund the current account deficit remains a source of macro vulnerability.
The outlook for monetary policy is balanced. A late-cycle global slowdown (Federal Reserve (Fed) pricing has taken a dramatic about-turn since late 2018) allays pressure on the Monetary Policy Committee (MPC). However, while inflation anchoring seems to be embedded in longer-term expectations, the weak fiscus presents a challenge to monetary authorities. Subdued core inflation and a clear absence of demand-pull or FXpassthrough all point to signals for lower interest rates. Real interest rates (r-star) are also arguably moving into restrictive territory. The make-up of the MPC could undergo significant change over the remainder of the year. These changes present volatility for the outlook. GLOBAL
The end of 2018 saw two narratives with very different consequences for global growth. On the one hand, significant equity market turbulence, tightening financial conditions, plunging PMIs, an escalating trade war, and increasing recession probabilities contributed to a negative spiral of news. On the other hand, unemployment continues to fall, labour force participation continues to improve, wages are on the upswing, and emerging markets overall are weathering the currency, financial, and trade storms with a good degree of resilience.
With the S&P 500 Index now up 13% year to date, 1Q19 marked the best first quarter since 1998 and the best quarterly gain since 2009 in the US, while 10-year Treasury yields fell to their lowest level since December 2017. Despite this move, analysts are rapidly changing their outlook for the US economy, with some now removing any further hikes in the cycle and shifting to forecast at least two cuts in 2020 (with the risk of a cut in 2019 rising). Recession fears are still a major part of market action.
It has become more likely that both the European Central Bank and Bank of Japan will struggle to hike rates, further supporting the view that we have seen the peak in bond yields.
The outlook for 2H19 will be important for the above view, as there can be no debate that several temporary shocks at the start of the year likely resulted in a meaningful slowdown in 1Q19 (government shutdown, slower pace of tax refunds, adverse weather conditions). Labour income growth has been steady throughout the current expansion, and the labour market is expected to remain tight during the current industrial production slump. A relatively high savings rate and healthy balance sheets offer additional resilience, even if income growth slows. However, while labour markets in most economies continue to support demand, the capacity of domestic strength to outweigh trade tensions is waning, as policy uncertainty is weighing on real and financial investment decisions.
Global growth has been subpar with mild deceleration, but the US recession risk does not presently seem a 2019 event (US growth revised downwards from close to 3% in 2018 to the 2% region - still above trend). Meanwhile, core inflation is expected to trend sideways around 2%. Central banks, the Fed in particular, also seem much better prepared for a recession relative to 2008. Risks to the US outlook are therefore roughly balanced: stillabove-trend growth, wage inflation still evident, firm business investment vs. threats to international trade, weaker than expected residential investment, potential disorderly asset price corrections.
While another opportunistic hike is possible, we expect the current level of the federal funds rate as at or near the terminal level of this hiking cycle. If faced with a sharper economic weakening than currently forecast, and heightened threats of a recession, the Fed could cut, and even aggressively so. This scenario would probably involve deterioration of jobless claims, trend payroll growth, the unemployment rate, manufacturing and non-manufacturing PMIs, and industrial production. But the Fed could also cut in the face of an adverse market event or disappointing inflation data. In the last two cases, the goal would be to extend the recovery.
For the Eurozone, growth is forecast to slow to a below-consensus 1.0-1.5% in 2019 from close to 2% in 2018. This view reflects the tightening in financial conditions in Italy as well as weaker global growth. In the UK, most investors expect a long Article 50 extension for Brexit, with no specified UK political process, followed by a second referendum, exit on terms specified by the current withdrawal agreement or general election, with only a small minority expecting no deal and reversion to World Trade Organisation norms to govern trade.
In China, 2019 growth should slow to the middle of a 5.5-6.5% range ? reflecting uncertainties caused by trade tensions with the US, domestic pressure to deleverage, and an economic policy with partially conflicting targets (growth and unemployment versus financial stability). We do expect signs of stabilisation to set in after the late-2018 slowdown, as the fiscal easing impact kicks in.
A moderate rebound in CPI to 2-3% is possible on rising energy and food prices, while the Peoples Bank of China is widely expected to cut reserve requirements further rather than cut rates. Any further depreciation of the Yuan against the Dollar is likely to be moderate unless trade negotiations between the US and China fail and tensions escalate. But we flag this as a key risk in our outlook ? and have done so for many quarters ? as the threat of a global trade war remains the key geopolitical risk in 2019. Based on the above developed market view, some breathing room may exist for emerging markets (EM). EM seems to be in a 'sweet spot' for four reasons. Benign inflation expectations, a dovish Fed and reasonable optimism about both Chinese stimulus and a US?China trade deal set the scene for the coming quarter. However, the latter two factors mean that the former two might not be very durable. China's downturn is at the heart of global disinflationary pressures, and the market's optimism about Chinese stimulus is thus at odds with the idea that this can persist. In addition, China's downturn has helped to justify the Fed's dovishness. A stabilisation in China could therefore revive expectations of Fed hikes. That's not a bad scenario for EM, but arguably not as good as the one EM has enjoyed the first two months of the year.
With central banks on the sideline, the Euro/US Dollar exchange rate broadly seen in the $1.20/$1.10 range, and Chinese stimulus putting a floor under commodity prices, a window for a local rally ? and, importantly, a recovery for cyclical SA Inc assets - might be open.
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