Lower speed limits for global growth
Last year’s global growth of 3.4% was in line with the average of the past three decades, but was unevenly distributed between different economies. The US continues to lead the developed world, despite recent data pointing to a soft first quarter. European economic growth is weak but starting to surprise on the upside.
Japan is struggling to maintain consistent, positive growth. China is slowing down and achieving the government’s 7% target could be a struggle. Other emerging markets continue to disappoint, especially commodity producers like Brazil and Russia, although growth in India is accelerating.
Potential growth lower
Looking ahead, the International Monetary Fund (IMF) warned last week that potential growth rates for emerging and advanced economies are lower subsequent to the global financial crisis. The economy’s potential growth rate – how fast it can grow before overheating and inflation accelerates – can be thought of as its speed limit.
While short term factors like exchange rate fluctuations or the interest rate cycle determine the speed at which an economy expand, the speed limit is determined by longer-term natural factors including the structure of the economy, the stock of capital, technology and skills levels.
In advanced economies, lower potential growth has been driven roughly equally by slower fixed investment and labour force growth (the latter influenced by aging populations). In emerging markets, much of the decline is due to slower productivity growth.
Private fixed investment growth is often depressed following a financial crisis, as firms and households repair balance sheets and credit is scarce. It is also very sensitive to perceptions of future economic activity. Firms experiencing weak sales and expecting slower future growth, cut back on investment spending, ultimately reinforcing the perception. But if economic conditions continue improving, fixed investment could rebound, which would in itself support growth - a virtuous cycle.
Governments can also take a longer-term view to increase fixed investment spending, but the fear of debts and deficits which have gripped politicians in the developed world since 2010, means this is unlikely.
Demographics are much less sensitive to economic conditions and the IMF expects slower growth in the workforces of both advanced and emerging economies. Productivity growth is a function of policies, education levels and technological adoption and innovation. The IMF is not optimistic that the current set of policies in the emerging world is conducive to fostering productivity growth.
South Africa’s speed limit also lower
The SA Reserve Bank and the IMF have, in separate studies over the past year, marked down South Africa’s potential growth rate from around 3.5% to about 2.5%. This means that not only are we not meeting our potential, but our potential is less than we thought. Lower potential growth means greater difficulty at tackling poverty as the economy is likely to create fewer jobs, but it also has implications for government’s borrowing and spending plans.
Lower potential growth creates headaches for policymakers. In advanced economies, the IMF warns that it will make it more difficult to reduce public and private debt levels relative to income, since income grows slower. In emerging market economies, lower potential growth will make it more difficult to reduce budget deficits.
What does a slower growing world mean for investors?
Lower potential growth rates imply lower real interest rate levels, meaning cash is an unattractive asset class. In a slow-growing world, bonds have done very well. But at ultra-low yields, only the expectation of outright deflation can justify buying bonds that yield almost nothing.
Last week, Switzerland became the first government to issue benchmark 10-year bonds with negative yields. As yields on government and corporate bonds have fallen, so have the yields on other investments with bond-like characteristics, including listed property and high dividend-paying equities.
Equities, as we’ve seen over the past few years, don’t mind slow steady growth. Even though top-line (revenue) growth is sluggish, the bottom line (profits) can expand at a fairly robust pace as financing costs are low (due to low interest rates) while other input costs (such as wages, raw materials and machinery) rise slowly or even fall.
While companies are not using low borrowing costs to invest in future production on any large scale, they have borrowed to buy back shares, boosting earnings per share, or to grow through acquisitions. The value of global mergers and acquisitions rose to $811 billion in the first quarter, according to Thomson Reuters, up 21% from the first quarter of last year. Recent examples of household name companies announcing massive acquisitions are Shell, Heinz and FedEx.
The last few years have been a goldilocks (not too hot, not too cool) scenario for equities in several markets, especially in the US. In Europe, where the economy has been ‘too cold’, equities have lagged. There aren’t many examples of economies overheating in the past seven years, but Brazil is an example of where the central bank is responding to high inflation by hiking interest rates. Brazilian equities have suffered badly.
If global economic growth accelerated meaningfully, would this hurt equity markets? Certainly top-line growth would improve, but input costs would also rise, and higher interest rates would follow the economic improvement. Higher rates would not only increase funding costs for companies, but also reduce the implied value of future profits due to higher discount rates.
This could lead to price-earnings ratios drifting lower, instead of higher (i.e. a market de-rating), but does not imply a major bear market. A 30% to 40% fall in equity values has historically resulted from an economic recession, where profits turn negative.
Recessions, in turn, are typically caused by a macro shock, such as the oil crises during the 1970s - which are unforeseeable - or as a result of more predictable overheating (causing inflation or debt bubbles), like when the economy crashes after exceeding its speed limit for a considerable period.
Chart 1: Equity indices including dividends since the end of the global financial crisis
SA mining stuck in a hole
Mining production rose strongly by 7.5% year-on-year and 3.8% month-on-month in February, according to StatsSA data released last week. However, this is a very good example of how headline numbers can be misleading, and why it is necessary to interrogate data from different angles. To start with, month-on-month rebound follows the very weak output in January, so it’s unlikely to be due to fresh momentum.
The rebound in year-on-year growth, from January’s 2.3%, is largely due to a base effect: a year ago platinum production was falling due to the strike. Indeed, February saw a 26% year-on-year jump in platinum group metals (PGM) output. However, the seasonally-adjusted index of platinum production that StatsSA calculates was at 82 in February, against 100 in the 2010 index base year.
Overall mining output index was barely above 2010 levels. Gold output, constituting 21% of local mining output, was almost a third lower in February than in 2010. Coal output, the largest contributor to local mining (26%), has moved sideways. The only parts of the mining sectors that have shown decent output growth over the past five years are metal ores – iron, chromium and manganese. But of these, only iron ore has a double-digit share of local mining production.
SA mining held back by numerous factors
There has been much discussion over the problems in South Africa’s mining sector. Cost pressures in the form of electricity and wages have increased sharply, work stoppages due to strikes or accidents have become frequent, and the lack of regulatory uncertainty has weighed on the sector’s long-term outlook.
Last week, the government and mining houses agreed to ask the High Court to rule on an interpretation of ownership in the black empowerment charter. While this is an important step, it does highlight the degree of uncertainty over existing regulations. The unreliability of electricity supply since 2008 has also been a major factor, given how energy-intensive mining, especially deep-level underground mining, is.
Although mining’s direct contribution to GDP is only 8%, it is a significant employer and consumer for the local manufacturing sector and export earner. A big part of the stubbornly large current account deficit can be explained by mining.
According to StatsSA, mineral sales - which capture the price and volume - were R26 billion in January. The same than what it was in August 2011. Over this period, there has been no growth in the revenues of South Africa’s mining sector, despite the fact that the rand fell from R6.90/$ to R12/$ recently. Lower dollar commodity prices, and sideways production, are to blame. For instance, the iron ore price has halved over the last year in dollars.
Shares reflect the troubles in the shafts
The impact has also been felt on the JSE. The three biggest miners on the JSE – Glencore, Anglo American and BHP Billiton - are global businesses and not specifically representative of the local industry, but some of the problems facing the local industry are present elsewhere in the world.
Most of the other mining shares do reflect local problems, notably the platinum miners. Over the past five years, none of JSE’s mining indices – general mining, platinum mining, coal mining, industrial metals and gold mining – have delivered a positive return, even including dividends.
Are they offering value? Mining shares are trading at a discount to the overall market. The 12-months forward price-earnings ratio of the JSE All Share Index is 16.4, while industrial metals (9.8), gold mining (15.2), platinum (15.7) and general mining (13.6) are all trading at lower valuations.
Low valuations give long-term investors protection, but there are still many risks that are not necessarily priced as most dollar commodity prices are still not cheap on a historic basis in real terms, while many commodity markets still face a supply. A strengthening US dollar is another potential headwind for commodities.
Chart 2: Output indices for South Africa’s four largest mining sectors, seasonally adjusted 3-month moving averages
Photo Caption: Izak Odendaal, Investment Analyst at Old Mutual Wealth.
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