Central banks either cutting interest rates or being expected to cut rates

Central banks either cutting interest rates_

Global equity markets held on to their strong gains from the previous month, with most global equity markets up by between 1% and 3%. The main theme for the month was central banks either cutting interest rates or being expected to cut rates. The lower interest rate outlook has created a very strong search for yield environment for bonds, with Greek bonds now trading at 2% (which is surprisingly under US 10-year bonds). Unfortunately, fiscal deficits that were much weaker than anticipated and political in-fighting have caused the South African markets to buck the trend, and both our equity and bond markets ended the month weaker.

In the United States (US), most indicators still confirmed our view that growth is decelerating closer towards trend. The second-quarter gross domestic product (GDP) number came out at an annualised 2.1%, beating market expectations of 1.8% but lower than the 3.1% of the first quarter. Household consumption and government spending added to growth, while a smaller inventory build and weaker exports detracted from growth. Consumer inflation fell to 1.6% in June from 1.8% in May, as food prices rose at a softer pace and energy costs fell. The core inflation rate edged up to 2.1%, beating forecasts of 2.0%. Markit Manufacturing Purchasing Managers’ Index (PMI) fell to 50.0 in July, the lowest since September 2009 and below expectations of 51.0. On the positive side, retail sales rose 0.4% in June beating expectations of 0.1%. This shows that the consumer is still doing well in the US, which is confirmed by the GDP numbers. Sales were boosted by purchases of motor vehicles and a variety of other goods. The unemployment rate rose to 3.7% in June from 3.6% in the previous month and above market expectations of 3.6%.

Data from the Eurozone remained mixed. The annual inflation rate rose to 1.3% in June from 1.2% in May. The biggest contributors to the rise were food, alcohol and tobacco, and services. Core inflation, which excludes volatile prices of energy and food, rose to 1.1% from 0.8% in the previous month. The European Central Bank held its benchmark rate at zero percent during its July meeting, but changed its forward guidance to say that it expects rates to remain “at their present or lower levels”, at least through the first half of 2020. A renewal of quantitative easing is also expected to be announced at their September meeting. The seasonally-adjusted unemployment rate fell to 7.5% in May from 7.6% in the previous month; the lowest jobless rate since July 2008. Manufacturing PMI dropped to 46.4 in July from 47.6 in June, the steepest contraction in the sector since December 2012 as manufacturers reported the second-largest drop in new orders since 2012.

In the United Kingdom (UK), Boris Johnson became the new Prime Minister. His commitment to the Brexit October deadline has increased the odds of a hard Brexit. Inflation remained steady at 2.0% in June, in line with expectations. The unemployment rate stood at 3.8% in the three months to May, its lowest level since the October 1974 to December 1974 period. Manufacturing PMI fell to 48.0 in June from 49.4 in May, well below market expectations of 49.2. This is the steepest contraction in the manufacturing sector since February 2013, as production contracted at the fastest pace since October 2012 and new orders dropped the most in almost seven years.

In China, the economy grew at 1.6% for the second quarter of 2019, accelerating from a 1.4% expansion in the previous quarter and beating market expectations of 1.5%. Notwithstanding trade wars, the trade surplus soared to US$50.98 billion in June from US$40.91 billion in the same month a year earlier. This was the largest trade surplus since December 2018, as exports fell 1.3% while imports plunged at a faster 7.3%. The Caixin General Manufacturing PMI fell to 49.4 in June from 50.2 in the previous month, missing market expectations of 50.0. This is the first contraction since February, as new orders, overseas sales and output all declined amid persistent trade disputes with the US. Inflation stood at 2.7% in June, unchanged from May and in line with expectations. Food prices, especially pork, contributed the most as the effects of the African swine fever are still boosting pork prices.

The Japanese consumer price inflation was unchanged at 0.7% year-on-year in June and in line with expectations. A faster rise in food prices and a pick-up in housing costs were offset by a steeper decline in transport and communication prices. Looming tax hikes are a threat to future household consumption. The Bank of Japan voted to keep all its key policy settings unchanged, from the short-term interest rate of -0.1% to the 10-year government bond yield target of around zero percent.

On the local front, inflation was unchanged at 4.5% in July, slightly above market expectations of 4.4%, but still in line with the reserve bank’s target rate of 3% to 6%. Main upward pressure came from housing, utilities and food while the cost of transport eased. The trade surplus came out at R1.74 billion in May, compared to a R3.43 billion deficit in the previous month. Exports jumped 8.1%, while imports increased at a slower 3.0%. The manufacturing PMI rose to 46.2 in June from 45.4 in May, though remaining in contractionary territory for a sixth consecutive month. The South African Reserve Bank (SARB) cut its benchmark repo rate by 0.25% to 6.5% in July, as widely expected. Policymakers noted that inflation expectations continued to moderate and said that they will continue to focus on anchoring it near the midpoint of 4.5%. The committee is, however, concerned about the fiscal issues caused by lower growth as well as further State-Owned Enterprises (SOE) bailouts, especially to Eskom. This in turn could cause a ratings downgrade, a potentially weaker currency and higher inflation. Fitch did change our rating outlook from “stable” to “negative” and Moody’s has warned that our fiscal deficit is ratings “negative”.

From a market perspective, the bond yield curve steepened even more during the month as the SARB cut short-term rates to spur growth and long-end bonds sold off on the news that Eskom needs further bailout funding. The JSE All Share Index was relatively flat for the month, losing out to stronger global markets.

Market outlook

The macro picture reflected an ongoing softening in the global economic environment. The pace of deceleration has, however, started to ease and there were signs that the global economy could bottom in 2020. The US economy remained on track to “catch down” to the rest of the world and the US dollar continued to be regarded as expensive. Inflation remains well contained globally and central banks have become more dovish in their rhetoric. The Fed fund rate is expected to be cut by 0.5% over the forecast horizon, although the market is pricing in the probability of more cuts. Trade war risks remain, but increased tariffs are likely to be accompanied by greater Chinese stimulus. Bond yield forecasts are higher than spot rates across the board. Global equities have more investment merit than global bonds based on an elevated earnings yield versus bond yields.

Locally, evidence of reform will be necessary to boost policy confidence and yield higher private sector investment. Economic growth will likely be constrained to below 2% until then. While we anticipate better than money market returns from growth assets over the next 12 months, mostly on valuation grounds, muted business confidence remains a significant impediment. An improvement in confidence would be required to generate returns in the double-digit range. Concerns over the fiscal deficit have risen sharply over the last few months as the country is experiencing low nominal growth (due to lower tax collections) and further SOEs (especially Eskom) bailouts. Rating agencies are voicing their concerns and Fitch (which already rates us at sub-investment grade) has changed their outlook from stable to negative. We expect Moody’s to do the same before year end.