Q2 provided a reality check, not only on the global economy, but also on the outlook for South Africa.
The shock 2.2% contraction in GDP and 4.8%/GDP current account deficit in 1Q18 emphasise that SA needs more than Ramaphoria to turn the ship. Moreover, policy uncertainty has resurfaced with the ongoing rhetoric about expropriation without compensation, the draft mining charter, and the draft National Health Insurance legislation. Eskom also peppered the headlines with a strained wage negotiation and dire funding needs, notwithstanding NERSA’s RCA allowance. Confidence indicators have rolled over and the consumer has faced a 1% VAT hike and a 16% rise in the local petrol price amid moderating wage growth. Downside risks to growth expectations abound.
The constrained domestic backdrop alongside low inflation should have given the SARB scope for monetary policy accommodation, but the Bank now faces global headwinds, rand weakness, and upside risks to the inflation outlook. Amid an EM sell-off, the SARB had little choice but to keep the repo rate unchanged at 6.50% in May. While the MPC will most likely stay pat in July, adverse forecast revisions will be accompanied by hawkish risks, leaving the probability skewed towards rate hikes over the next 12 months.
The shift in SA’s policy outlook is largely due to tightening global financial conditions. The Fed has become more hawkish and rising US deficits have started to pull capital out of the rest of the world. The ECB announced the taper in a dovish manner by pushing the timing of the first hike outward. Growth and policy divergence have favoured the US dollar, with the sharp increase in the oil price being a further drain on liquidity, notwithstanding higher effective production from OPEC.
Escalating trade tensions are the main focus for markets given the uncertainty associated with a drawn-out tit-for-tat game that no one will win in the end. In the meantime, US assets benefit relative to the rest of the world. Estimates vary, but further escalation could cost the global economy as much as 0.5% of GDP when including spill-over effects to financial markets, confidence and capex plans. A full-blown trade ware will push the world into recession.
With such a backdrop, SA will be under renewed scrutiny, bringing fiscal, SOE and twin-deficit risks back into focus.
SA markets showed divergence during Q2, but the shifts were not enough to change the year-to-date leader board, where fixed income remains in poll position. Equities outperformed in 2Q18 (+4.5%), followed by floating rate credit (2.8%) and cash (1.8%). ILBs underperformed (-4.5%), followed by nominal bonds (-3.8%), property (-2.2%), and fixed-rate credit (-0.5%).
The US dollar index rallied 5.0% in Q2 with the bulk of the gains coming during May when US bond yields and Fed hiking expectations rose sharply. Escalating trade tensions, political dynamics, and tightening liquidity conditions triggered broader risk aversion towards EM assets. While the rand’s 14% depreciation was largely a dollar story, the large downside surprises in SA data and renewed concerns about politics contributed to the currency’s underperformance. USD/ZAR has moved above our fair-value range (12.50 – 13.00), leaving the currency around 5% undervalued.
Following a brief spike above 3.00% the US 10-year yield has retreated to 2.85% due to the relative attractiveness of US vs. other DMs, safe-haven demand, and a moderation in upside US data surprises. The SA 10-year yield rose by 85bp during 2Q18, driven by higher US yields and a widening SA sovereign risk premium. SA’s CDS spread is trading at similar levels to the time of the 2017 MTBPS, suggesting excessive risk is being priced into the curve. Net foreign selling of R68bn of SA bonds in Q2 has more than reversed the R25bn of net inflows during 1Q18.