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ECONOMIC OUTLOOK

Maarten Ackerman
Chief Economist and Advisory Partner

 
ANOTHER MOUNTAIN TO CLIMB

“After climbing a great hill, one only finds that there are many more hills to climb.” One of Nelson Mandela’s most famous quotes, this is an apt description of where we find ourselves when looking at both the global and local economic and political landscape.

Global economies are making good progress, especially developed markets, which have typically done better in terms of their vaccine rollouts. This is encouraging, because it suggests vaccines are working and that some semblance of economic normalcy is returning. Those economies which are lagging in terms of their economic recovery, are those that are falling behind in vaccinating their populations.

Global growth is up, and the International Monetary Fund (IMF) is predicting a global expansion northward of 6% for 2021, the highest growth number we have seen since the 1980s. However, unlike the global recovery that followed the 2008 financial crisis, it must be noted that while 2020 saw a synchronised global economic decline, the current recovery is very diverse, due to the uneven vaccine rollout.

China led the recovery at the start of the year. The United States (US) has now taken over, and we expect the European Union (EU) to outpace US recovery within 12 months. We believe this will result in a sustained global economic recovery. Over the next three to five years, we are expecting global growth to remain elevated, at around 4.5% per annum which is the highest growth rate the world has seen in modern history, and certainly the highest in the last 50 years. So, from an economic point of view, things are looking good.

Economic data is supporting our view. Global trade is already higher than pre-COVID levels. They are, in fact, to date, the highest they have ever been, which is very positive. In addition, global savings are the highest they have ever been. There is currently US$5.4 trillion of post-COVID savings in the pipeline. The Organisation for Economic Co-operation and Development (OECD) has noted that household savings rates across the G20 countries are the highest that we have seen in the last century. As consumers pick up their spending, this will have a spillover effect onto the service industry (after mostly spending on goods during lock down), paving the way for companies to increase capital expenditure, which will further support global economic recovery over the next few years.

Economic recovery was front of mind at the recent G7 summit, which saw Canada, France, Germany, Italy, Japan, the United Kingdom (UK) and the US meet. With a view to preventing further pandemics in the future, their focus for the future can broadly be placed into four priorities: health, the environment, general values, and research. One thing that did stand out at the summit was the mild, but balanced critique leveled at China for human rights abuses and at Russia for aggression towards the Ukraine. What was clear is that the G7 is pushing for greater free trade, which is a positive sign that they support rebounding economies and believe things are looking solid.

However, despite all this positive sentiment, we need to be careful of downside risk. If the developed world does not help their developing counterparts roll out vaccination programmes, we are going to continue to see more and more mutations of the virus, like the Delta variant, spring up. This would potentially see the world forced into further lockdowns and another recessionary environment. So, we cannot become complacent.

IS AMERICA GREAT AGAIN?

Turning to the different major regions, America is currently one of the top performing countries when it comes to the fight against COVID. US President, Joe Biden is adding to the country’s appeal. Since taking power, Biden has moved to repair many of the bridges burned by his predecessor, Donald Trump. Under his leadership, we’ve seen the US rejoin the Paris Climate Agreement, the World Health Organisation, and play a significant leadership role at the G7 summit.

At home, the US is making excellent progress with a solid first quarter GDP which came in at just over 6%. Underpinning this growth is an increase in personal consumption, which is a big driving factor, as the US is a consumer-based economy. Spending was up more than 10% quarter-on-quarter. This was largely driven by a 20% increase in goods. Now as the economy opens up further, we are seeing an increase in services, notably flight and holiday bookings, which is good news because 70% of US consumption is service based. This paves the way for a strong US economy over the next few years.

US retail sales have also rebounded strongly, with a 20% jump year-on-year. This shows us just how strong the pent-up demand is from US consumers and is another indicator that the US economy is opening up. Retail sales and consumer confidence are now back to pre-COVID levels.

This growth will be further supported by the stimulus in the pipeline, elevated household savings, and although not yet set in stone, Biden’s proposed infrastructure development programme. US growth will contribute significantly to the historically high global growth we are currently seeing.

More good news for the US is that the country is getting close to what they call full employment. This is important, because the US Federal Reserve (Fed) is looking at employment numbers (over and above inflation) and when full employment is realised, we should start seeing some sort of normalisation of their monetary policy.

Although employment is looking good in the world’s largest economy, they are battling to fill certain jobs. This is probably because many people want to continue working from home, want to avoid possible contact with the virus, and/or are still getting financial stimulus from the government – although we expect this support to end in September. This inability to fill jobs is driving the US wage bill higher, with average hourly earnings having jumped 7.5% year-on-year.

With a stronger job market, higher wages, huge pent-up demand, and many supply bottlenecks spilling over from last year’s lockdowns, inflationary pressures are building. This year alone, we have seen inflation rise above 5%, which is much higher than the Fed expected. These factors may force the Fed to take a hawkish approach to stimulus sooner rather than later. We are expecting to see the Fed potentially reducing stimulus in the next 12 to 18 months. The first step towards normalising monetary policy is crucial for where markets go from here.

So, given the US’s strong economic rebound, we expect their economy will reach pre-COVID levels by the end of this year, going into 2022. In summary, Citadel expects US growth to exceed 6% this year. This will taper down, but we will still see healthy growth of around 3% for the next couple of years, which is a strong economic environment for companies to operate in.

EU CLOSING IN ON US

Europe, with France and Germany being front-runners, is closing in on the US with its vaccine rollouts, which is good news for the bloc’s economy. If the EU continues with this rate of vaccinations, we expect its economic growth to outpace the US in the next 12 to 18 months.

Benefitting from the vaccine dividend, eurozone economies are opening up with business and consumer confidence increasing. European businesses are reporting the fastest expansion in activity for 15 years, with a lot of it on the manufacturing side. European manufacturing has also benefitted from the growth in the global economy, and the Purchasing Managers Index (PMI) remains elevated way above 50, which shows the economy is in strong expansion mode. As the economy continues to open, further similar increases on the services side should be evident soon. We are seeing a strong rebound in retail sales, and industrial production reaching pre-COVID levels. As such, EU economic momentum is building, which is supporting employment across the bloc, as people return to work.

As in the US, these demand and supply factors should contribute to higher inflation. We have noted, though, that inflation in the EU is rising less sharply than in the US, and the European Central Bank (ECB) expects these concerns to fade over the next year. If the ECB does not view inflation as a scenario risk in the near future, they are unlikely to start normalising monetary policy or hiking interest rates before 2024.

This year, we are expecting the EU to grow by around 3%. As their momentum builds, their economic growth should outpace the US economy in 2022 and achieve slightly above capacity growth for a few years to come.

CHINA REBOUND COOLING

The Chinese economy started normalising in the middle of 2020 and now their growth is cooling. With fears of the economy overheating, China has started pulling back stimulus, which contribute towards an economic slowdown and a moderation of Chinese data. But we must realise that this is coming off a very high base, so while we talk about a moderated Chinese economy, we were seeing levels of growth upward of 9% last year, 8% this year and now slowing down to 6%, which is still very solid growth.

Chinese trade with the US is up 80% year-on-year and imports from the US are up 60%, indicating that, despite tensions between the countries, the world’s two major economies are still very dependent on one another. PMI is also very solid and is above pre-COVID levels, which indicates that China is still in expansion mode despite economic growth cooling down. Retail sales are also moderating from very high levels on the back of the opening up of the economy. But, consumption spending is still 18% higher than it was in 2019, online retail is up 32% and auto sales are up 16%. With these figures, we expect to see some inflation pressure building.

China will continue to make a strong contribution to global growth. But their stimulus or leverage will be much less, which will see the country move from a supercharged recovery to more sustainable growth. At Citadel, we expect the economy to return to trend-growth which will be around 5% to 5.5% over the next three to five years.

SOUTH AFRICA: GLASS HALF FULL OR HALF EMPTY?

Generally speaking, things are looking better for South Africa. Although the country is experiencing adjusted levels of lockdown in an attempt to curb the third wave of COVID-19 infections, the economic impact should be manageable over the short term. Obviously sectors like hospitality and tourism will be impacted, but the government has learnt some valuable lessons when dealing with the pandemic. We do not expect to see a full hard lockdown again as it is important for people to make a living. We also believe lockdowns will be over shorter periods. Furthermore, as we continue with the vaccination programme and build towards herd immunity, it is less likely that we will see further strict lockdowns even if we have more waves from infections. This is clear from the other parts of the world where they are almost fully vaccinated.

Unfortunately, over the same period, the country was dealt another blow as violence erupted after the arrest of ex-president Jacob Zuma. These events and destruction of economic capacity will negatively impact the country’s current economic recovery. This has put strain on business confidence, as well as the African National Congress’s (ANC) ability to maintain control in a country beset by poverty, unemployment, and extreme inequality (the structural issues that needs to be addressed as a matter of urgency).

However, over the last month, the country has experienced some much-needed structural reforms. Reforms that were needed years ago, but which can make the “glass full” sooner than expected. If we can overcome the current short-term challenges (which in South Africa we typically do) these reforms and staying the course will pave the way to remove many of the structural hurdles preventing strong economic growth. It started with the ruling party, the ANC, asking members to step aside if they have been charged with corruption. This was followed by ANC Secretary General, Ace Magashule’s suspension. That has given President Cyril Ramaphosa some breathing space to make the hard decisions. We then saw the announcement that SAA was to be privatised and the 100 MW cap on private power production without a license lifted, meaning businesses, like mines, can now start generating their own power for private use – a game changer for energy supply in South Africa. Other reforms included the announcement around the restructuring of the ports authority and government sticking to below inflation wage increases. Despite the recent violence, the arrest of Jacob Zuma is a clear signal about the strength of our courts, democracy, and constitution.

We believe that these are all steps in the right direction and if the short-term political turbulence around these can be managed appropriately, an environment can be created to attract investments and set South Africa back on a sustainable growth trajectory.

Another positive for South Africa was that Ramaphosa was the only African head of state to be invited to the G7 summit held in the UK in June. We see this as important because it speaks to his role as a statesman on the global stage as the world looks to Africa as the future. While the rest of the world is ageing, Africa is getting younger, and many see this as a major opportunity. We believe the West is waking up and realising that they need to get involved with the continent. A critical point, however, is that Africa needs global support when it comes to a vaccine rollout. Without continental immunity, the world is still at risk of an ongoing pandemic and further mutations. Furthermore, the West is now in a race with China to invest in Africa to ensure that China doesn’t consume the continent for its own benefit.

So, if we look at the fundamentals of the economy, things are positive. We have seen very strong retail sales, underpinned by low interest rates and a recovering consumer base. Some jobs have been recovered after the pandemic and consumer confidence is returning. Mining and improved commodity prices have been a major contributor to stronger economic growth in the first quarter, with mining rebounding 18% over this period. The sector, which is an important job creator in the economy and contributor to South Africa’s tax revenue, helped towards the better-than-expected government revenue and a smaller budget deficit.

Further good news comes from ratings agencies, who expect South Africa’s growth to exceed expectations. Although the country is still dealing with structural low growth, high debt, and record-high rates of unemployment, confidence is being boosted by the fact that the country has low foreign debt level, and that many of our institutions, like the South African Reserve Bank remain strong. We are also starting to rebuild institutions that have experienced setbacks of late. However, if these structural headwinds are not addressed, the country’s trend-growth over the next five years will remain weak.

While South Africa’s economy is looking stronger with 4.6% growth in the first quarter, and an expected 3.5% growth for 2021, we must speed up our vaccine rollout, as further lockdowns could hamper growth. The recent violence also needs to be addressed and those responsible should be arrested. Over the next two and a half years we expect growth to settle at 2.5%. While we expect the global economy to get back to pre-COVID levels in 12 to 18 months, given South Africa’s challenges, we are only expecting a return to pre-COVID activity a few years down the line.

Lastly, the rand has been very strong coming into this year. In fact, it has been one of the strongest currencies against the dollar. Given South Africa’s structural challenges, it means our currency is quite stretched. Other currencies in our peer group have all performed poorly against the dollar.

One of the reasons for the rand’s strength was our positive trade balance. But with our economy opening up, we believe this tide will turn. Already our exports are flat, and our imports are up 23% over the first quarter. We expect to be printing a trade deficit again in the next 12 months. This is going to impact the value of the rand. We believe that fair value of the rand is around R16 to the dollar, and the currency should trade towards that level over the next few months. Already, the recent violence, has had a negative impact on the currency level.

INVESTMENT LANDSCAPE – THRIVING IN CHAOS

Management guru, Tom Peters, noted in his book, Thriving in Chaos, that if you are not confused at this point in time, you are not paying attention. And when you are bombarded with a lot of moving parts, equity markets, economic growth, the pandemic, vaccines, anti-vaxxers, Tesla, Bitcoin, and a myriad of others, making sense of the global economy requires a holistic understanding of how the different asset classes function within a given economic environment.

An important starting point, in today’s economy, is that markets have been buoyed by extreme policy support. But despite this, the global recovery is holding momentum and on the back of the recovery, many companies will generate solid earnings.

To ensure sustained growth, it is critical that the stimulus that has buoyed markets now translates into fundamental factors like higher earnings. As markets reach all-time highs, we must also not jump to the conclusion that we are going to automatically enter another bear market, as strong fundamentals can support new highs going into the future. So right now, Citadel is confident that there are currently no indications of another recession in the near to medium term. However, higher inflation figures, and how central banks deal with this, will cause some investor anxiety and market volatility. When bond yields react to higher inflation expectations, it can suck liquidity out of the system. But this speaks more to volatility than a double-digit decline in equity markets, that typically denote a bear market.

When it comes to our portfolios, we believe a strong global economy should support company earnings, meaning we should have exposure to solid, quality companies, especially if you think you are going to be in a three-to-five-year strong global economic environment. Even with inflation, these companies do have pricing power and can stay ahead of inflation. So potential volatility is not a sign to reduce global equity exposure.

When it comes to traditional prudent assets like global cash and global fixed income, we feel they are still very unattractive with yields at or below zero and definitely below inflation. Traditionally we would have used these to reduce volatility, but we are staying away from the fixed income space right now because there is just no return. We believe you should only have cash in your portfolio to cover your immediate expenses and not use it as a risk-mitigating tool. Instead, we would look at alternatives, that include managed equity strategies, hedge funds and gold, which often act very differently in a volatile environment.

If we turn to the local market, South African equity will benefit from a global rebound. However, performance of local equities is very diverse, with a number of companies, especially on the retail side, still experiencing strong headwinds. These will only benefit when the economy opens completely and the economic fundamentals improve.

We prefer to be overweight on global equities at the moment. But it is not a country-specific argument, it is about diversification and valuations. You get many more sectors internationally. That is not to say there are not some untapped opportunities in the local market.

When it comes to local bond markets, we are aware of the potential fiscal risks that may impact bond investments, like the risk of a debt spiral – borrowing to pay off interest. However, currently this risk is only likely two or three years down the line and only if the country does not address the current issues holding back growth. With current bond yields still around 8.5%, and well in excess of inflation, we believe that exposure to this asset class can add good value to a multi asset portfolio.

Finally, the JSE used to be a good proxy for emerging markets (EM), but the EM space has changed over the last few years and is now much more driven by Asia which makes up over 40% of the index. There are many more sectors in the Asian EM space that you will not pick up in South Africa. These markets are not just about mining and resources; they include a lot of tech and biotech, for example, sectors which we are very light on locally. So, when we look at the case for emerging markets, excluding China, although they may be lagging now – due to slower economic growth, structural issues and slow vaccine roll out – we believe, in time, they will benefit from the pickup in global the global economy, stronger trade, and faster vaccine roll outs. The JSE has done well on the back of mining, but commodities are not a sure bet. We believe that we can complement our local and global equity exposure with an allocation to emerging markets that will give us a more diverse exposure to these upcoming regions.