Calmer markets reflect on earnings
World markets seem to have calmed down somewhat after the volatility of the past few weeks. The VIX is back below 20 and the safe-haven US 10-year Treasury yield climbed to 2.2%. Equity markets pared some of their recent losses.
European deflation concerns remain
The growth concerns in Europe receded slightly after better than expected flash Purchasing Manager’s Indices (PMIs) showed increased economic activity in the Garman manufacturing sector, the engine of what little growth there is in Europe, particularly looked a bit stronger after a string of soft economic data.
However, France, the second largest economy in the Eurozone, is still in negative territory and the PMIs point to further downward pressure on both input and output prices throughout the region. Deflation risks are real and it remains to be seen whether the European Central Bank has the ability to tackle the problem.
In contrast, its US counterpart, the Federal Reserve (Fed), has shown a willingness to take bold steps. Partly as a result of its actions over the past six years, the US economy finally seems to be in good enough shape for interest rates to start their journey to more normal levels from the middle of next year. By the same token, lower inflation means they don’t need to rush normalisation.
Japan, another major economy struggling to grow after the sharp tax hike in April, also posted a positive first estimate PMI. Japan’s manufacturing PMI rose to 52.8 in September. Prime Minister Abe also recently suggested that next year’s planned tax hike could be stopped. While PMIs from Europe and Japan don’t point to a growth acceleration, it also doesn’t indicate a collapse in growth.
Slower growth in China, but is it better growth?
Growth concerns in China also receded marginally as new gross domestic product data for the third quarter showed that the economy grew at a slower pace than the previous quarter, 7.3% year-on-year, but at a higher pace than expected.
There can be no doubt that China’s economy is slowing across a broad front – from retail spending, to industrial production to fixed investment. However, there is no collapse yet, and also no indication that the authorities in Beijing will launch broad-based stimulus measures like they’ve done in the past. Slower growth is also not necessarily bad news if it points to a rebalancing process underway.
Already, there are early signs of household incomes growing faster than overall economic growth. This suggests households getting a bigger share of the economic cake. The key risk remains the property market that is in parts oversupplied and in other parts overvalued. Commodity prices seem to now more properly reflect lower Chinese growth rates.
Earnings season in full swing
The other reason markets are slightly calmer is simply that corporate results from the US have been better than expected (excluding oil producers and miners of course). Of the S&P 500 companies that have reported results, around two thirds have beaten expectations for top line (sales) and bottom line (profit) growth.
Since the reason most investors buy equities is to get a claim on the profits companies generate, there’s no reason to panic if these profits are still growing. The sustainability of future profit growth is, however, key and here some of the macroeconomic concerns come into play. Since the S&P 500 companies are largely global, they are impacted by slower growth in Europe and Emerging Markets as well as the impact of a strong dollar when bringing profits ‘home’ to the US.
Results from local companies continue to show the opposite effect, namely the benefit of bringing profits ‘home’ from abroad at a very weak exchange rate. While the rand is off its most recent lows against major currencies – the Mini Budget being was well received by the foreign exchange and bond markets - and even broke through R11/$ last week, it remains very weak. Unfortunately it also remains vulnerable to further weakness given the uncertain global environment and our large funding needs.
Chart 1: Equity indices since September
Tightening the fiscal and monetary noose
The two big items on the local economic calendar last week were the Mini Budget and the September consumer inflation numbers. Both proved newsworthy. The Medium Term Budget Policy Statement (MTBPS), to give the Mini Budget its full name, saw reality sink in for both government and taxpayers.
As Minister Nene noted, fiscal consolidation cannot be postponed further. Running large deficits, as the government has done over the past six years, means that debt levels have risen substantially. Just the interest payments on government’s debt is expected to be R150 billion by the 2017 fiscal year, double the 2011 level and on par with current social grant payments.
Failure to close the deficit now implies interest payments will crowd out of other spending priorities. For this reason, the Minister announced that the expenditure ceiling will be lowered over the medium term, meaning government spending will grow slower than projected at the time of the February Budget Speech (only slightly above anticipation inflation).
The expenditure ceiling is a ‘red line’ that National Treasury will not allow to be crossed. What happens ‘below’ the ceiling is a matter of trade-offs between different spending priorities within and between departments and agencies.
One of the biggest priority areas is currently the salary bill for government employees. If allowed to grow at more than inflation, it will crowd out other spending areas, including much-needed infrastructure investments.
The expected ratio of the budget deficit to GDP, the number the markets and ratings agencies care most about, will be 4.1% in the current fiscal year, narrowing gradually. As expected, the Treasury’s outlook for economic growth was cut to 1.4% for 2014, rising gradually to only 3% by 2017 (whereas in February the government expected 3%-plus growth next year already). The deficit ratio will only be smaller than the expected growth rate by 2016, meaning that government debt levels will only stabilize then.
Weaker expected economic growth means the government will have to turn to increases in tax rates – or new taxes altogether – to generate the required revenue. The adjustment will thus fall both on the spending and the revenue side, a blow to the South African economy in the short term. The details of the tax changes will be announced at the February 2015 Budget Speech. It promises to be the most closely watched by market participants and ordinary South Africans in recent times.
Lower than expected inflation
Consumer inflation fell to 5.9% year-on-year in September, from August’s 6.4%. The market expectation was for inflation to drift lower to 6.1%. Lower transport inflation was the main contributor to the lower inflation rate compared to August.
Petrol prices were only 1.1% higher in September compared to a year ago. After the price cut this month, annual petrol inflation should moderate to around 0.1% in October and turn negative next month (based on the current average under-recovery of 31c/l). Vehicle prices rose at a slower annual rate of 5.9% in September from 6.5%. The gap between new and used vehicle prices widened further in September.
Food and beverage inflation declined from 9.4% year-on-year to 8.5%. Most food items showed slower price gains over the twelve months to September, with oils and fats showing an outright decline (it has a very small weight). Based on falling inflation at the producer level, particularly grains and cereals, food inflation should continue slowing in the months ahead.
Core inflation rose marginally to 5.7%, suggesting a limited – but persistent – ‘second-round’ impact from the weak rand. Actual and implied rents were surveyed in September, but annual growth rates in these important items (15% of the total) remain subdued at 5.2% and 4.9% respectively. Underlying inflation pressures in the economy thus appear to be fairly well contained, while the volatile food and energy items are set to provide downward pressure over the coming months.
Inflation within the target range, but further hikes loom
Inflation has fallen into the SA Reserve Bank’s 3% - 6% target range earlier than expected. This will give it some breathing room at the November Monetary Policy Committee meeting since all the recent economic growth indicators are pointing to sustained weakness.
However, South Africa’s real interest rate is low and our current account deficit large compared to our emerging market peer group. This means that the rand is still exposed as US rate hikes start coming into view. The Reserve Bank will probably continue to gradually increase interest rates. Both fiscal and monetary policy will be tighter in the year ahead.
Chart 2: SA inflation drifted lower in September
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