First quarter confirms local and international markets are under pressure
The first three months of the year have seen equity markets experience their worst start to a year on record. This was “fuelled” by the ever-dwindling oil price, while concerns over economic growth in China did the markets no favours either. Investors found their only hiding place in developed market government bonds, which coincidentally offered the worst risk/reward profile. And yet, despite the blood on the floor, there is still money to be made and reason for optimism.
One reason for the latter is that recessionary fears were based on an underestimation of the major central banks’ resolve to get their economies back on sustainable growth paths. Incisive action by the European Central Bank, the Bank of Japan, and the US Fed, caused financial turmoil to subside and equity markets started to rally by the end of the quarter.
The concerns over China that were in part responsible for the dislocation of the markets at the start of this year also proved to be premature. The most recent data confirms that far from imploding, the world’s second-largest economy stabilised during the first quarter. GDP expanded by 6.7%, which is slightly down from the previous quarter, but still within the revised growth target range. The economy, on which so much market sentiment is dependent, showed growth in the property sector, new credit, exports, industrial production, fixed asset investment, and retail sales.
Despite these promising signs, investor confidence remained low, which weighed heavily on the markets. The oil price distinguished itself as the barometer for investor sentiment and daily movements in global equity markets showed an uncannily strong correlation with daily fluctuations in the price of oil during the quarter. However, as fears of a hard landing in China subsided, commodity prices and emerging market assets appreciated.
Locally, the outlook is less positive and the economy likely stagnated during the first quarter of the year. While the challenging global backdrop certainly played its part, local conditions such as soft commodity prices and one of the worst droughts on record exacerbated the situation.
Matters were not helped by the country’s well-publicised political shenanigans. The clear rift between the Finance Minister and other parts of government’s leadership, and accusations of state capture, along with the Constitutional Court’s ruling that President Zuma flouted the country’s constitution, harmed both investor sentiment and the country’s image.
In addition to the damage caused, it also drew attention away from the reforms necessary to put the country on a sustainable recovery path. Compounding the effects of a growth slowdown was the extension of the domestic interest rate hiking cycle coming into the New Year.
As a result, first-quarter growth was weak. Until the end of February, manufacturing production was flat, but mining activity slumped and the Mining Production Index reached its lowest level in four years. New vehicle sales were negatively affected by the depreciation of the rand and used car demand outstripped that of new vehicles for the first time since 2009.
The strong budget speech delivered by the Finance Minister might not be enough to stave off a ratings downgrade later in the year.
Looking ahead, both local and global growth remains under pressure. The economic recover of the last few years continues to remain fragile and with deflationary concerns continuing to dominate, the status quo will most likely remain. However, fears of another recession are overdone, particularly in the light of the actions taken by the major banks, as well as the stabilisation of the Chinese economy and the oil price.
Economists will watch the referendum on whether Britain remains in the European in June with great interest, as a Brexit could do damage by disrupting existing trade relationships between the UK and European Union. The UK will be worse off, however, as a greater percentage of its exports go to Europe than other way around. The economic and political effects of the continued influx of refugees into Europe will also be a key talking point. But tail-risk events aside, European economic growth and the slow recovery will continue to muddle along with the support of the European Central Bank’s monetary policy stimulus.
The market’s fixation with the oil price is also likely to diminish.
Locally, the market is currently pricing in another two interest rate hikes, which will take the repo rate up to 7.5% at the end of this year. That should push the interest rate hiking cycle close to its peak.
There is a real risk that Standard & Poor’s will cut the country’s investment grade rating to junk as soon as its June meeting. This is already partially reflected in the local bond market, but many passive foreign investments will only leave the country once it falls out of the Citigroup World Government Bond Index. If the country loses its investment grade rating, funding the current account deficit will also become increasingly difficult, leaving the country even more exposed to large external vulnerabilities that will keep the currency under pressure.
Household consumption will also remain vulnerable to high interest rates and the current resilience in retail sales seems unsustainable. Lower-income households will be worst hit, especially as drought-induced food price increases start to take hold. There has also been an increase in distressed borrowing as disposable incomes remain under pressure. Weak employment prospects, as well as lower investment spending by both the public and private sector will further weigh down on the local economy.
In addition, the supply and demand outlook in many of the country’s commodities remains unfavourable, which means that the recent bounce in commodity-related companies’ share prices is unsustainable and that investors will probably look elsewhere for value.
In summary, the year ahead is bound to be difficult for both local and international economies. Therefore, it will be vitally important for investors to rather stick with their investment horizons and not be overly influenced by short-term noise.