Yes, no, maybe?
The US is, or rather was, in a technical recession in 1H22, as confirmed by the Q2 GDP data released in late-July. The performance in the equity market would align with a technical recession, but unfortunately a technical recession is not a real recession, at least not as defined by the official recession scorekeeper, the National Bureau of Economic Research (NBER). Moreover, we have to keep in mind that the GDP data will be revised over time and that revisions tend to be positive. Hence, this technical recession could disappear from history somewhere down the line.
According to the NBER, a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” On this basis, the US is not in recession, given the low unemployment rate, positive household consumption growth, an ISM above 50. Other data – such as factory and durable goods orders, as well as house price momentum and fiscal revenues – remain in positive territory. Granted, activity growth has moderated, but it is not in a slump, yet. Much of the GDP volatility in 4Q21 through 2Q22 was due to swings in inventories and net exports, which tend to be quite volatile and rarely in isolation cause a real recession.
Yield curve says the US is headed for recession
Globally, central bankers seem comfortable enough with the growth outlook to continue to tighten policy to address inflation. The Fed hiked by a second 75bp in July, on the eve of the negative GDP print, while the ECB kicked off its normalisation cycle with a 50bp increase off a negative base.
Yet the macro backdrop keeps evolving and past policy actions affect the economy with a lag. The yield curve is one indicator that is signalling recession. Yes, the yield curve is not a fool proof predictor of recessions, particularly given the distortions created by ZIRP, NIRP, and QE, but the 2-year/10-year US yield spread is now negative enough not to be ignored.
So is the US in recession? No. Is the US heading towards a recession? Probably.
Yet the conviction with which market participants hold this view differs. The New York Fed’s recession probability model is based on the 3-month/10-year US yield spread. This measure is currently in positive territory at around 30bp and would broadly equate to a recession probability of around 25%. Participants in the monthly Bloomberg economic survey are somewhat less optimistic, with the median probability of a recession pitched at 40%.
If the Fed continues to lift the policy rate into restrictive territory, then this curve will very likely turn negative, signalling a higher probability of a recession. A clear dovish pivot is required very soon to re-steepen the curve. Yet this may already be too late given the tightening impact already in the system.
SA at risk of a technical recession
Bringing it home, the local yield curve has lost its predictability of the economic cycle due to the impact of the weak fiscal position. Yet the local economy has rarely escaped a global slowdown.
The incoming data for Q2 point to a contraction, driven by the KZN floods, load shedding, and China lockdowns. The severity of the load shedding will also weigh on Q3 activity, risking a technical recession in South Africa. Business confidence has declined and consumer confidence is aligned with previous recessionary levels.
Yet other data suggest some resilience – the trade balance remains healthy, even within the context of import normalisation, while fiscal revenues are holding up well.
SARB will do whatever it takes
The SARB has become increasingly focussed on inflation, following the global policy bias. With CPI breaching 7.0% in June, a sharp jump in inflation expectations, and a more aggressive Fed, the MPC hiked the repo rate by 75bp at the July meeting. This was an upside surprise relative to the analyst consensus, but in line with market pricing.
The hawkish rub was in the voting breakdown, where one member favoured for a 50bp increment, but another opted for a 100bp hike. Moreover, the statement and post-meeting Q&A session elucidated that the SARB’s primary mandate is price stability and that it would do what is necessary to maintain its credibility.
While this triggered a reassessment that the SARB is willing to normalise more rapidly, since then some inflation inputs have rolled over. Global grain prices, oil prices, and refining margins are trading in line with their pre-war levels. This should give the bank some breathing room in the near-term inflation releases, allowing for a slower pace of hikes.
The upside risk to the September MPC meeting stems from the Fed and how it views the nascent signs of the peak in inflation in contrast to a still strong labour market, and from the BER Q3 inflation expectations survey in light of the 7.0%+ CPI prints.
It is not all doom and gloom
July ended with much needed reform action as President Ramaphosa announced substantial energy sector interventions. In addition, media headlines indicated that plans are afoot to move part of Eskom’s debt onto the government’s balance sheet. Unfortunately, announcements alone will not lift the growth trajectory. We need implementation.
Much of this success will depend on how the political economy evolves and on the outcome of the ANC elective conference in December. The outcome of the KZN ANC provincial election portrayed a weakened CR faction, but the importance of the province has arguably waned. Similarly, the ANC’s policy conference delivered a mixed bag, but it does seem that the president managed to hold the line.
It is clear that 2H22 is shaping up to be interesting, albeit with much volatility.
Following a challenging quarter for risk assets, markets recovered in July with only inflation-linked bonds (-1.2%) underperforming cash (0.4%). The rebound in listed property (8.8%) partially recouped the June losses, while equities (2.8%) marginally beat fixed-rate bonds (2.4%). The rand lost 2.2% against the US dollar, which would have been accretive to offshore returns.
Euro taking strain
The DXY dollar index rose by 1.2% in July, with the gains entirely versus the euro. EUR/USD temporarily broke parity mid-month, following the upside CPI surprise in the US, which spurred expectations for a 100bp rate hike from the Fed. Recession fears in the US have been exacerbated by the impact of the Russia/Ukraine war on the Eurozone, which supported safe-haven demand for the greenback.
The dollar’s gains were reversed in the latter part of the month with the Fed hiking by “only” 75bp amid what seemed like a dovish pivot to be shortly followed by a downside surprise in Q2 GDP.
Less so for EM FX, rand fairly valued
While the softer dollar gave EM FX some reprieve, EM currencies were still net down 2.4% for July. The weakness was driven mainly by EMEA, with the Russian rouble losing 13% during the month. The rand posted a middling loss of 2.1%, reflecting weaker commodity prices, recessionary concerns, and the dollar’s gyrations.
Prudent domestic macro policy and a current account surplus are offsetting global recession fears and tightening liquidity conditions, leaving the rand in line with our 15.50 – 16.50 fair-value range on USD/ZAR.
Fed action lowers long-term yields
Longer-dated DM bond yields rallied in July as hawkish central bank rhetoric and action spurred recession concerns. The US 10-year yield fell by 37bp, to 2.65%, while the TIPS yield declined by 57bp, to 0.1%. Breakeven inflation widened modestly on the dovish interpretation of the July FOMC meeting, even as the Fed delivered the priced 75bp hike.
Short end yields moved higher as the upside inflation surprise spurred hawkish expectations. The net effect was an inversion of the US yield curve based on the 2-year/10-year yield spread, to almost -25bp. The last time the curve was similarly inverted was in 2006/2007, ahead of the 2008/2009 recession, and in 2000, ahead of the 2001 recession.
Credit spreads and EM had a wild ride in July
The combination of more hawkish Fed expectations and a pending recession widened credit risk premia sharply in the first have of the month. As DM yields rolled over mid-month, credit spreads contracted, spurring a rally in EM hard currency and local currency bond yields.
EM yields declined a net 36bp, on average, in July, but this belied notable intra-month volatility. South Africa’s 10-year yield sold off by more than 50bp, to 11.50%, only to recover by 70bp. Even so, the SA market lagged the broader EM complex in the rebound.
Despite the deterioration in the inflation outlook, inflation-linked bonds were not spared during the EM rout. The SA 10-year real yield rose from 4.00% to 4.40%, almost keeping base with the nominals. The widening in breakeven inflation, to over 7.0%, was quickly reversed during the market recovery.
Local market fairly valued amid non-resident selling
We view the local market as fairly valued, with the 10-year yield close to 10.7% and ILB yield close to 4.00%. That said, the inflation outlook, positive cyclical dynamics, and excess risk premia already embedded in the very steep curve favour nominal bonds over inflation-linked bonds at this stage.
According to the official National Treasury statistics, non-resident investors sold R16.6bn worth of fixed rate bonds in July. The implied net supply to domestic investors of R43bn was taken up almost entirely by the banking sector (R40bn), as unit trusts turned marginal net sellers of bonds during the month. The share of government bonds held by foreigners declined to 26.5%, which is the lowest level since May 2011.
Recession risks trump supply constraints in commodities
Commodities prices were not immune to mid-month strain from mounting concerns over a global growth slump. The steady increase in TIPS yields, more hawkish Fed, and stronger dollar weighed on prices.
Despite persistent supply constraints and the ongoing war in Ukraine, the oil price dipped below US$100/bbl in July alongside a decline in refining margins. This fall has filtered through to notable declines in retail fuel prices, both in the US, as well as in South Africa.
The gold price was under notable pressure from the stronger dollar and hawkish Fed expectations, which countered any inflation-hedge properties in the precious metal. However, the decline in the TIPS yield as recession fears pared monetary policy expectations allowed for a moderate recovery in the latter part of the month, leaving the price down only 2.4% for the month.
Moderating grain prices, but long-term supply still uncertain
Despite the ongoing war in Ukraine, expectations of the export deal dampened global grain prices, with corn and wheat trading at their pre-invasion levels. This has not yet benefited SA grain prices, which remain elevated, despite healthy inventories and positive harvest expectations.
Whether global prices will continue to moderate is uncertain in light of dry conditions in the north and western parts of the world, as well as the potential for a moderate La Nina event towards the end of the year. This usually leads to dry conditions in US and LatAm planting regions. In contrast, La Nina benefits SA rainfall, although excess rains can complicate planting and harvesting if conditions are too wet.
While lower iron ore (-5.8%), gold (-2.4%), and platinum (-1.0%) prices weighed on SA’s terms of trade, these were offset by gains in palladium (11.1%) and rhodium (2.5%), as well as the lower oil price (-4.2%). On balance, the recovery in the commodity prices in the latter part of the month aided the rand and SA’s credit spread.
Surprisingly strong equity rebound on hopes of peaking inflation
Global equity markets rebounded in July as recession fears gave way to hopes of the turn in inflation and less hawkish monetary policy. Cheaper valuations trumped negative (modest) earnings revisions, enticing investors back into the asset class. The S&P 500 gained 9.1% and the Eurostoxx rose by 7.2% in July, but year-to-date these benchmarks are still down by 13.3% and 14.4%, respectively.
The MSCI World Index gained 7.9% in July, sharply outperforming the 0.2% decline in the MSCI Emerging Market Index. China was the main culprit dragging down EM, with the MSCI China Index losing 9.5% amid limited policy support in the face of weaker-than-expected growth. More than half of the EM indices ended in the black in July, with the MSCI South Africa Index eking out a 0.3% gain.
Partial recovery in SA with wide-ranging, albeit positive sector gains
The ALSI and SWIX rose by 4.2% and 2.8%, respectively, in July, which made up for less than half of the June losses. Consumer discretionary (11.6%) and health care (6.8%) outperformed following previous underperformance, as well as signs of more resilient domestic demand.
Telco’s (5.5%), industrials (5.2%), and financials (4.6%) also beat the market, being defensive in the context of the global growth slowdown and commodity price volatility. Telco’s also benefited from M&A talk between MTN and Telkom. Consumer staples (1.7%), basic materials (0.8%), and technology (0.6%) lagged the market, but managed to avoid declines. Basic materials were depressed by lower commodity prices, particularly oil on chemicals, as well as lower platinum and gold prices.
The local equity market continues to trade at a substantial discount to its historical rating, as well as EM and DM markets. Global recession fears, weak consumer and business confidence, and tightening monetary policy are weighing on the outlook. Structural constraints – particularly electricity supply – could start easing notably over the next 12- to 24 months. This will require increased fixed investment that could crowd in a broader capex recovery. This, alongside the ongoing normalisation in tourism, poses upside risk to earnings growth in the medium term.