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ECONOMIC OUTLOOK

Maarten Ackerman

Chief Economist and Advisory Partner

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2020: SOME MORE UPSIDE FOR MARKETS, BUT TURBULENCE AHEAD?

The two key geopolitical issues that have plagued the global economy over the past few years, namely Brexit and the United States (US)-China trade war, came to a head in the last quarter of 2019. With demonstrable headway finally made on both these fronts, markets look set to enter 2020 with slightly less geopolitical uncertainty than was the case at the beginning of 2019.

 

In the United Kingdom, the Conservatives’ landslide victory in the December election placed Prime Minister Boris Johnson firmly in the driver’s seat, with a strong mandate to push through a Brexit deal. British MPs subsequently voted in favour of his Withdrawal Agreement Bill. This means that the threat of a highly disruptive no-deal Brexit, one of the greatest risks facing global markets in 2019 (and more specifically Britain and Europe), is now firmly off the table.

 

Additionally, the phase one trade deal between the US and China first announced in December 2019 was recently signed, representing a significant first step towards a long-awaited truce in the trade dispute. While this is far from the end of the trade war saga, it does represent some progress in negotiations, shifting some of the uncertainty which has been weighing on global sentiment. 

 

In more good news for markets, 2020 is also a US presidential election year, which typically bodes well for market performance. The US market historically delivers a strong performance during election years, as the country’s leaders generally make a special effort to support the economy and markets ahead of the vote – this also accounts for some of President Donald Trump’s sudden eagerness to conclude a trade deal.

 

A reduction in uncertainty, combined with the fact that most leading indicators suggest that the softness in the global economic environment appears to be bottoming out, would indicate that we can expect a rebound in economic growth for 2020.

 

Furthermore, as many as 66% of all central banks around the world began opening the taps and easing monetary policy during the course of last year, while the major ones, including the European Central Bank (ECB), Bank of Japan and the US Federal Reserve, expanded their balance sheets by some US$100 billion a month in 2019.

 

Seen together with China’s recent bout of monetary and fiscal stimulation and the management of its currency, this means that there is a great deal more liquidity in the financial system at the start of 2020 than in 2019. This should support macro-economic data and business sentiment throughout the coming year.

 

For investors, this bodes well for a reasonable economic outcome this year, with global growth expected to reach about 2.5%; this should provide enough support for markets to generate positive returns.

DOWNSIDE RISKS FOR 2020

This said, the sudden tension in the Middle East following the killing of Iranian general Qasem Soleimani by the US, and the retaliatory bombing of two US military bases in Iraq, could inflate oil prices over the next few months, effectively representing a tax on the global economy.

 

It is common for US presidential incumbents to provoke some cross-border tension in order to show muscle in the run-up to elections, however, these developments also remind us that while Brexit and the US-China trade war are slowly being resolved, unforeseen geopolitical events still have the power to stir up market uncertainty and volatility.  

 

Another key threat to markets in 2020 is the risk of growing protectionism, a trend in evidence around the world and particularly in the US, where it gave rise to the US-China trade war. The trade dispute has lasted 20 months, and we have seen in that short time how much of an impact trade conflicts can have on market sentiment and global growth.

 

Although the phase one deal has now been signed, this represents the closing of merely one chapter in the saga. Notably, the phase one deal specifically avoided addressing a few key bones of contention between the two nations such as China’s alleged cyber theft of US intellectual property, or the Chinese state’s provision of subsidies to its state-owned enterprises (SOEs).

 

On top of that, there is the risk that the US may now turn its attention to Europe, and specifically Europe’s auto sector, as Trump threatened last year.

 

Finally, while US consumers continued to fire on all cylinders throughout 2019, in spite of the trade war, perhaps the biggest risk to global growth is the possibility that this strength could begin to wane. A dip in US consumer demand would represent a major obstacle to the US economy and the rest of the world.

US CONSUMERS HEALTHY, BUT WARNING LIGHTS FLASHING

As expected, the US manufacturing sector contracted in 2019 in the face of ongoing trade tensions. In a ripple effect, corporates also saw a decrease in profitability coupled with rising debt levels.  

 

The irony, of course, is that Trump’s trade war has hurt the sectors it was supposed to help the most: manufacturing and trade. The blue collar states that voted Trump in are, in fact, taking the most pain with those areas proving the hardest hit by a decline in manufacturing output. This state of affairs may also be contributing to Trump’s newfound sense of urgency in reaching an agreement with China.

 

However, as previously mentioned, on the whole US consumers remained fairly healthy financially last year as a shortage of skilled workers continued to place upward pressure on wages. This has, in turn, supported economic growth through consumer spending.

 

Additionally, the housing market remains robust, as the number of permits issued to build new homes in the US reached a 12-year high in 2019. This situation is not expected to change any time soon, particularly given the highly accommodative monetary conditions at play.

 

This balancing act between a struggling manufacturing sector, stressed corporates and rising corporate debt levels on the one hand, offset by healthy consumers, a strong housing market and easing monetary policy on the other, implies that the US will still achieve capacity growth of around 2% this year.

 

However, there are warning signs that the impact of rising headwinds is likely to make itself felt over the next few years, slowing growth to below capacity or sending the US economy into recession. For instance, corporate debt is now outpacing housing debt for the first time since 1991, corporate earnings growth declined from 10% per annum to around 5%, small business capital expenditure declined significantly during the course of last year, and the service sector is currently printing the lowest growth figures seen in six years, although these are still positive.

 

Together, these factors signal that businesses could soon begin cutting back on wages, denting consumer pockets and taking the wind out of the country’s sails.  

 

All told, while a US recession remains unlikely in 2020, we will be watching for signs of any deterioration in the job market during the course of the next 12 months, since this would place pressure on consumers and trigger an economic slowdown in the region. Overall, the red lights have begun flashing and it is simply a matter of time before companies begin retrenchments and we see a reduction in household income.

THE LONG NIGHT FINALLY ENDS FOR EUROPE

The past year was indisputably another tough one for Europe, as the trade war and consequent decline in global manufacturing and trade took their toll on exports from the region. Germany and Italy were particularly hard hit, although the situation effectively placed a chokehold on growth for the entire region.

 

As one of the region’s main economic powerhouses, Germany was also hard hit by new regulations which saw a slump in auto production, while the Brexit sword continued to hang threateningly over the whole region.

 

Most signs would indicate, however, that the new year could finally be better for Europe. The uncertainty and chaos stirred up by Brexit is nearing its conclusion and most economic indicators, including the Purchasing Managers’ Index (PMI), seem to be bottoming out and stabilising, paving the way for a rebound which should boost business confidence in the coming months.

 

Furthermore, Germany has introduced fiscal stimulation in the form of consumer subsidies for the purchase of electric vehicles and broadened corporate tax benefits, which should lift business sentiment and underpin economic activity. Likewise, the ECB has also committed to offering support to the region’s economies through monetary stimulation.

 

The euro is currently fairly cheap or undervalued, lending additional competitiveness to exports, and a simmering down in trade war tensions and more receptive global environment spells good news for exporters.

 

On the consumer side, employment levels remain healthy and wages are actually increasing at levels last seen before the 2008 global financial crisis, a development which bodes particularly well for the region given that a number of its countries have consumer-based economies.

 

Together, these factors suggest that 2020 will be a better year overall for Europe, and we anticipate that the region will achieve growth of some 1.5%.

DESPITE STIMULATION, GROWTH IN CHINA SLOWING

China’s economic growth slowed somewhat in 2019, owing in part to trade tensions, but also due to the fact that the Chinese economy is slowly maturing and is unlikely to deliver the same level of growth that it has in the past.

 

China’s government, however, continued to offer targeted support to offset this slowdown while still pursuing its strategy to gradually transition away from its focus on infrastructure development to a consumer-led economy. Measures taken included: reducing the reserve requirement ratio for banks; offering consumers tax cuts amounting to some 2.8% of GDP; boosting expenditure at SOEs; issuing grants for a number of targeted infrastructure development projects; and implementing business-friendly policies, which saw its ranking on the World Bank’s Ease of Doing Business Index rise to 31 from 46.

 

And, in more good news, the retail sector grew a healthy 7.5% in 2019, while PMI numbers suggest that the downward trend in the manufacturing and service sectors has bottomed out, and should begin to rebound on the back of the recent stimulation.

 

That said, investments into the Chinese economy slowed to their lowest levels since 1998, and structural downward forces mean that its growth is likely to continue to decline. So, while the Chinese government is targeting 6.5% in 2020, in our opinion it is more likely to achieve around 5.5% for the next few years.

 

The effect of all its spending should, however, not be underestimated. To put this into context, China’s fiscal deficit more than doubled from 3% of GDP to as much as 6.5% in 2019, and the impact of this stimulus is likely to make itself felt over the next few months, thereby supporting global growth.

SA BALANCING ON A KNIFE'S EDGE

The events of the past 12 months gave rise to a long list of both positives and negatives for the country. This mixed bag of pros and cons have effectively cancelled each other out, which accounts for South Africa’s continued economic stagnation.

 

Positives include government’s renewed focus on eliminating corruption and mismanagement, which saw a number of changes in the boards of SOEs as well as the arrest of several high-profile former ministers and political figures, a move which may (hopefully) soon result in some prosecutions. It is worth noting that the National Prosecuting Authority was allocated additional funding, which is another positive sign that efforts are afoot to hold corrupt individuals to account.

 

Despite opposition from labour circles, Finance Minister Tito Mboweni’s economic blueprint for South Africa was largely accepted by the ANC’s National Executive Committee, and President Cyril Ramaphosa took the additional step of appointing an 18-member Economic Advisory Panel to aid in devising policies to kick-start growth. 

 

Certainly Ramaphosa’s foreign investment strategy appears to be working, as Foreign Direct Investment (FDI) numbers began to rebound at the beginning of 2018, a trend which is continuing on the back of government’s investment drive.

 

Likewise, government has acted on its aim to enable entrepreneurs to register new businesses within the space of a day with the creation of the new online company registration portal. This should improve the country’s ease of doing business.

 

In addition, the opening of special economic zones (SEZs) that offer incentives for companies in various industries to do business has made the country more attractive. Notably, the automotive SEZ in Tshwane now looks set to become the largest hub in the world for producing SUVs, taking over from Taiwan. Local vehicle exports reached a record high in 2019.

 

On the downside, SOEs continue to grapple with serious financial issues which urgently need to be resolved. These challenges are weighing heavily on government’s balance sheet, drawing much-needed funds away from critical areas in urgent need of attention. Perhaps most importantly, government needs to deliver on a plan to stabilise Eskom and the country’s power supply, this as rolling blackouts resumed anew in December and continued into January this year, effectively strangling growth.

 

Government’s growing fiscal deficit and precarious financial position were laid bare in the February Budget Speech and emphasised again in the October 2019 Medium Term Budget Policy Statement. Mboweni has made it crystal clear that, based on our current trajectory, it is only a matter of time before South Africa loses its last investment grade credit rating.

 

The current low-growth environment and numerous fiscal challenges mean that a Moody’s downgrade is almost guaranteed during the course of the coming year, the prospect of which is sapping investor confidence. And while South African Airways (SAA) was placed in business rescue and the SAA board refused to give in to trade union demands for an 8% wage increase, Ramaphosa seems to lack the political capital to make the tough decisions.

 

Since government has all but run out of time to take action and halt the economy’s slide ahead of the 2020 February Budget Speech, markets have largely begun to price in South Africa’s likely move to junk status. Business and consumer confidence has thus reached decade lows. Last year saw a record net selling of local bonds and equities as foreigners began selling South African assets and instead turned their focus to seeking alternatives.

 

Whether or not South Africa is downgraded, government must urgently begin implementing the reforms needed to turn the economy around if it is to free the country from its current low-growth trap and address the key social ills of poverty, unemployment and inequality.

 

That said, even if all the right policies and reforms are implemented, 2020 is likely to see another year of below-capacity growth. Only by addressing critical issues such as Eskom and continuing the FDI drive are we likely to see any rebound in economic data in the next two to three years. 

 

Economic growth for 2019 is thus likely to total less than 0.5%, and will probably only achieve 1% this year. Although, with the right policies in place, growth may reach higher in the future.

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INVESTMENT OUTLOOK FOR 2020

While 2020 looks set to deliver reasonable global growth, indicators suggest that we are on the last leg of the current bull run. Investor would, therefore, do well to be cautious.

 

Although we are not yet at the point where we fear that a massive correction may be around the corner, the recent Iranian situation demonstrates just how quickly sentiment can change and volatility can re-enter the system. Therefore, given Citadel’s own focus on wealth preservation, we will be using the risk-on rallies to take profits and de-risk portfolios, rather introducing more defensive alternatives into the mix such as protected equity, hedge funds and cash.

 

We still prefer an overweight to global equity markets with exposure to higher economic and profit growth at more reasonable valuations compared with our local peers. Global fixed income remains unattractive and it is only US bonds that offer some value – as a result most portfolios remain underweight the asset class and are likely to stay that way given the outlook for global fixed income markets. US enhanced cash does offer a much better risk-adjusted alternative in the current market.

 

Looking to the local market, and against a bleak local backdrop, the rand is likely to remain under pressure over the next few months. This, together with a global risk-on rally, should offer JSE-listed multinationals and rand hedge stocks some support.

 

Unfortunately, SA Inc companies, or those locally-facing businesses that generate revenue predominately from within the country’s borders and are directly tied to the South African economy, seem to be in for another tough year.

 

Overall, from a valuation perspective, pockets of the JSE appears relatively attractive. However, given the difficult environment at present, investors will need the time and patience to see the positive effects of reforms come through before its value unlocks.

 

In terms of bond markets, with yields north of 9% and inflation below 4%, SA bonds are currently offering investors some of the highest real yields in the world. And given that more than R60 billion in local bonds were sold off in 2018, and around R35 billion in 2019, those foreign investors who are concerned about the country’s fiscal situation and the possibility of a downgrade have already exited the market.

 

However, a downgrade would likely see SA bond yields moving higher, which will result in capital losses for existing investors, but will also create a highly attractive buying opportunity. This would, no doubt, generate a high level of interest among those foreign investors whose mandate allows them to invest in sub-investment grade emerging markets, and would also offer local investors highly attractive yields, especially in tax-friendly vehicles such as retirement annuities, pension funds and provident funds.

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