A flight to safety

August was a dismal month for risky assets, with most equity indices falling between 3% and 5%. The sole reason behind the negative performance can be placed on the escalation of trade wars, mainly between the United States (US) and China. A flight to safety meant that only the risk-off safe havens did well, with gold up 9%, the yen 3% stronger and the VIX Index up from 15 to 20. Central banks have either cut interest rates or are expected to cut rates to ease financial conditions.

South African markets performed even worse than the average for the month, as the global risk-off environment led to disinvestment from foreigners, reducing both their equity as well as their bond exposure.  

In the US, most indicators still confirmed our view that growth has decelerated to a little below trend. New home sales fell 12.8% in July to a seasonally adjusted annual rate of 635 000; the biggest monthly decline since July 2013. The IHS Markit Manufacturing Purchasing Managers’ Index (PMI) dropped to 49.9 in August, below market expectations of 50.5. This pointed to the first month of contraction in the manufacturing sector since September 2009. The University of Michigan’s consumer sentiment fell to 92.1 in August 2019 from 98.4 in the previous month. That was the lowest reading since January, as monetary and trade policies have heightened consumer uncertainty about their future financial prospects. Despite these negative numbers, the US consumer held up well, with retail sales for July up 0.7% in July 2019, easily beating market expectations of 0.3%. Consumer inflation rose to 1.8% in July from 1.6% in June, boosted by food prices and a range of other goods, while energy deflation eased. The unemployment rate remained unchanged at 3.7% in July. The Federal Reserve lowered the target range for the federal funds rate to 2% to 2.25% during its July meeting, as inflation remained subdued amid heightened concerns about the economic outlook and ongoing trade tensions with China. Most Federal Reserve policymakers viewed the July cut as a
“mid–cycle” adjustment, thereby indicating that we should not expect a deep cutting cycle.

Data from the Eurozone was mostly negative. Gross domestic product (GDP) growth was confirmed at 0.2% in the second quarter of this year, compared to 0.4% expansion in the previous period. Germany’s GDP contracted 0.1% – mainly due to a slump in exports, Italy’s economy stagnated, France slowed to 0.2%, and Spain’s GDP grew at 0.5%. The annual inflation rate decreased to 1% in July from 1.3% in June. It was the lowest inflation print since November 2016, as costs went up at a softer pace for energy and services. Core inflation, which excludes volatile prices of energy and food, was confirmed at 0.9%, down from 1.1% in the prior month. Industrial production slumped 2.6% from a year earlier in June 2019. This was the steepest downturn in industrial activity since December, driven by capital and intermediate goods. The IHS Markit Manufacturing PMI rose to 47 in August from 46.5 in the previous month. This was the seventh consecutive contraction in factory activity. 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.

In the UK, the threat of a hard Brexit intensified as the deadline draws closer. Inflation rose above the Bank of England target rate of 2%, printing 2.1% in July from 2.0% in the previous month, as prices increased at a faster pace for recreation and culture and restaurants and hotels. The unemployment rate edged up to 3.9% in the second quarter of 2019 from a 44-year low of 3.8% in the previous period. Gross domestic product expanded 1.2% year-on-year in the second quarter of 2019, slowing from 1.8% in the first quarter and missing market consensus of 1.4%. Household expenditure rose 1.8% and government spending advanced 2.7%, while fixed investment growth slowed to 0.5% amid a further decline in business investment (-1.6%). On a quarter-on-quarter basis, GDP contracted by 0.2%, the first contraction since the last quarter of 2012. The Bank of England’s monetary policy committee (MPC) voted unanimously to hold the bank rate steady at 0.75% during its August meeting, and reaffirmed its pledge to gradual and limited rate rises under the assumption of a smooth Brexit and some recovery in global growth. Manufacturing PMI came in at 48.0 in July, unchanged from the previous month.

In China, data remained mixed. The Caixin Manufacturing PMI rose to 49.9 in July from 49.4 in the previous month, still pointing to a slight deterioration in business conditions. Inflation rose to 2.8% in July from 2.7% in the previous month. That was the highest rate since February 2018, boosted by food prices, especially pork prices in the wake of an outbreak of African swine fever. The trade surplus soared to $45.05 billion in July from $27.49 billion in the same month a year earlier and above market consensus of $40 billion. Exports rose 3.3% to $221.5 billion, while imports declined 5.6% to $176.5 billion.

The Japanese economy grew 0.4% quarter-on quarter in the three months to June 2019, beating market expectations of a 0.1% expansion. This marked the third straight quarter of GDP expansion, supported by robust private consumption and solid business investment while exports declined. Consumer price inflation fell to 0.5% in July from 0.7% in June, in line with expectations.
The trade deficit widened to ¥249.6 billion in July, from ¥227.4 billion in the same month a year earlier, as exports fell 1.6% while imports dropped at a slower 1.2%. The Bank of Japan left its key short-term interest rate unchanged at -0.1% at its July meeting and kept the target for the 10-year government bond yield at around zero percent, as widely expected. They also indicated that they would not hesitate to take additional easing measures if the economy loses momentum for achieving the central bank’s 2% inflation target.

On the local front, inflation fell to 4.0% in July from 4.5% in June, well below market expectations of 4.4% and the midpoint of the Reserve Bank’s target range of 3% to 6%. This is the lowest rate since January, amid a decrease in fuel cost. The trade surplus rose to R4.42 billion in June from a downwardly revised R1.7 billion in the previous month. Exports fell 3.2%, while imports declined at a faster 5.8%. The unemployment rate increased to 29% in the second quarter of 2019 from 27.6% in the previous period. It was the highest jobless rate since the first quarter of 2003, as the number of unemployed people rose by 455 000 to 6.65 million and employment rose by 21 000 to 16.31 million. The Manufacturing PMI rose to 52.1 in July from 46.2 in June.
The reading marked the first expansion in factory activity since December 2018, boosted by improvements in new-sales orders and business activity. However, manufacturing production fell 3.2% from a year earlier in June 2019, against market expectations of a 1.8% rise. It was the first downturn in factory activity since last September. Retail sales went up by 2.4% year-on-year in June, boosted by household furniture, appliances and equipment and textiles.

From a market perspective, the JSE Top 40 Index fell by over 3% and the US dollar/rand exchange rate depreciated by over 7%. Bonds at least had a positive return for the month, with the ALBI Index up just over 1%.

Market outlook

The macro picture reflected an ongoing softening in the global economic environment. The pace of deceleration has, however, started to ease and is likely to flatline before heading up again towards the latter part of 2020. This is, however, based on the assumption that there will be no further significant deterioration in the trade wars. Trade war risks remain, but increased tariffs are likely to be accompanied by greater Chinese stimulus. The uncertainty around trade wars has increased the possibility of a recession, but this is not our core view. The US economy remained on track to “catch down” to the rest of the world and the US dollar continues to be regarded as expensive. Inflation remains well contained globally and central banks are expected to cut rates further. 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 bailouts of state-owned enterprises (especially Eskom). 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. We have downgraded our growth forecast for this year to 0.3%.