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Citation – Second Quarter 2023

ECONOMIC OUTLOOK

ENTERING A DANGER ZONE

Maarten Ackerman
Chief Economist
Estimated reading time: 19 minutes 43 seconds read

As we enter the second half of 2023, the global economy is entering an economic danger zone, which is signalling a possible sharp slowdown in economic activity over the next few months.

Given our two key themes of peak inflation and peak interest rates, over the next 12 to 18 months the global economy will hit the bottom of the current economic cycle, before starting to pick up, forming a classic J-curve recovery over the next few years. But before the uptick in two to three years’ time, we need to prepare ourselves for a volatile period over the next 12 to 18 months as we move through the economic bottom – which might include a recession. And as such, the Citadel Asset Management team is making sure that our portfolios are robust enough to weather this trough in the cycle.

An imminent recession

Over the last two editions of Citation, we have talked about the Citadel Recession Score Card, which gives us an indication as to how close the United States (US) and global economy may be to entering a recession. The score card looks at 10 indicators, and rates them as green, orange or red. Over the last 12 months, those indicators have moved from predominantly green and yellow to predominantly red. But we are not alone in our analysis.

Recent research by EPB Research suggests the same. The research compares the annual change in the US leading indicator, which indicates what the US economy is likely to do over the next 12 to 18 months, with the Coincident Economic Indicator, which tells us what the US economy is doing presently. Each progressive signal is a sign that the economy is moving closer to recession, and this research reveals:

  • The first signal lit up at the beginning of this year. This indicated that the US/global economy was starting to move towards below-trend growth. Trend growth is defined as the growth in productivity coupled with the growth in population.
  • The second signal, which is the stage we currently find ourselves in, lights up when the economy moves from below-trend growth to pre-recession. We are already deep into this phase.
  • The final signal turns on when the economy goes into a full-blown recession. While the EPB research suggests that the US/Global economy is not there yet, it is just a matter of time until it reaches that point.

What the EPB research stresses, however, is that there is a lag before signals light up. This means that by the time the third and last signal suggest the US economy is in a recession, the recession will already be in an advanced stage. That is why we believe the global economy is in a danger zone. This period is where the United States Federal Reserve (Fed) and investors can be blind to the recession as they believe it can still be avoided.

When the economy finds itself in the space of the third signal, job losses become inevitable. This ties in with what the Citadel Recession Scorecard is suggesting. Of the ten Citadel recession indicators, the last domino to fall was US unemployment. Up until now, the US labour market has been robust. However, in the first quarter of 2023, the indicator has turned red suggesting that employment can soon come under pressure leading the economy into recession.

Some other indicators that are important to look at include US retail sales, which are down close to 5% from a year ago. Following on from retail numbers, consumer confidence and consumption have also turned from yellow to red, meaning the consumer is showing signs of strain. The state of the real estate market also suggests that the US economy is slowing down as a result of the massive increase in mortgage rates over the past year. The yield curve, which is the difference between short- and long-term bond yields, is at its most inverted since the early ‘80s.

On a positive note, global trade, which is also a strong indicator of global economic health, is moving sideways and has started pointing to some improvement over the past few months. What is interesting, however, is that as we approach the bottom of the economic cycle, the US leading indicator has already moved from red to yellow. We will likely start seeing more yellow up on our score card as the J-curve starts to develop after the economy finds a bottom in the next 12 to 18 months.

Despite these signs, we do not think the global downturn will be as severe as the recessions of 2008 and 2020. In summary, our assumption is that global growth will average about 2.5% over the next three years. That will be made up of well-below capacity growth for the next 12 months, before moving to above capacity growth in three years’ time.

US – Cracks starting to show

The Fed is now becoming more aware that there is a real risk of a recession, given that unemployment is set to continue to increase towards the end of the year. The risk of recession and the pain inflicted by the excessive rate of interest rate hikes are starting to show with the emergence of a banking crisis, which is of concern to the Fed. US Bankruptcies have also spiked and are at their highest levels since 2020. Currently the US is seeing around 70 bankruptcies a month, due to businesses not being able to keep up with the high interest rates.

In addition, as mentioned, the US consumer is under immense pressure, which will lead to less spending and possibly more job losses. Adding to this, the Dallas Fed Manufacturing Index which looks at the manufacturing and industrial production side of the economy, shows numbers have been declining and are at levels last seen during the recessions of 2008 and 2020.

Despite knowing its monetary policy is putting pressure on many sectors of the US Economy, the Fed is between a rock and a hard place, because while they are starting to see some cracks in the economy, core inflation remains sticky. Its decisions going forward will determine whether the economy has a soft or a hard landing.

Taking the data into account, we believe that the US will have well-below capacity growth for the next 12 months, in the region of 0.5%, which points to a soft landing. We then expect growth to start recovering to rebound to about 2.1% in three years’ time, giving the US an average growth rate of 1.5% over a three-year horizon.

EU – Confidence up but growth down

The European Central Bank (ECB) has been hiking rates as fast as the US, and Germany is already in a recession. But the ECB is still very concerned about the region’s sticky inflation, despite a strong decline in energy prices. We expect the Central Bank to continue hiking rates for the foreseeable future. Like the US, European Union (EU) inflation has been supported by a resilient labour market and strong wage growth. Now with Germany in recession, the EU’s ‘canary in the coal mine’ is signalling a warning, because when Germany – a large global exporter – starts to struggle, it is indicative that the global economy is already under pressure.

To illustrate what is happening in Germany, the country’s industrial production has fallen at its fastest pace in a year, and in terms of output, its production levels are below the COVID-levels of 2020. However, there has been a recovery of German business sentiment and consumer confidence, following their fall to levels last seen in 2020 and 2008. On the consumption side, despite the uptick in consumer confidence, Germany’s retail sales have also slumped by 5% compared to a year ago, showing that consumers are feeling the cost-of-living crisis and have started spending less.

With Germany already in a recession, the EU finds itself in a similar position to the US, where it sees the bottom of its economic cycle within the next 18 months. If you look at the expected growth numbers for the EU, the J-curve is also evident. We expect 0.4% growth for the next 12 months, picking up to above-trend growth of 1.6% over the next three years. This will see the EU experience an average growth of 1% per annum over the next 36 months.

UK – a bleak economic environment

Given BREXIT and the state of the global economy, the UK is experiencing real headwinds in terms of its competitiveness, downward pressure on its currency, upward pressure on inflation, limited capital goods inputs and a tight labour supply. These factors have all contributed to slightly higher inflation than the EU has experienced. The country is also in for a deeper recession compared to its mainland neighbours.

The data indicates that the UK consumer is under pressure, and when we look at metrics like housing affordability, we see that more than 1.4 million homeowners, half of whom are under 40, will be forced to refinance their mortgages over the next couple of months, according to the Institute of Fiscal Studies. This finance will be at much higher yields due to increased interest rates, and these young consumers could need to use as much as 20% of their disposable income to pay rising borrowing costs. UK inflation is currently at 6.8% which is still well above the 2% the Bank of England (BoE) is wanting to achieve, which means that the BoE will hike rates again in the second half of the year. While the UK is currently moving towards peak interest rates, we do not believe it is there yet. When it comes to home loans, most have yields north of 6%, coming off a base of 0%, just a year ago. In addition to hurting homeowners financially, this has also resulted in UK house prices declining at their fastest rate, to now equal those last seen in 2009.

UK retail sales further indicate that consumers are under pressure, and like the US and EU, have dropped significantly from what they were a year ago. In the UK, however, there is the phenomenon of “buy now and pay later” interest-free shopping, so although consumers don’t necessarily have money, they are still spending. This type of spending has surged of late and is further indication that consumers are struggling financially as the loss of disposable income to higher interest rates is having a massive impact on their ability to spend. If mortgage rates remain at around 6%, then it is estimated that 8.5 million people are paying more than a fifth of their family income on home loans.

On a separate, but equally worrying note, UK government debt has risen to 100% of GDP for the first time since 1961. But when compared to its counterparts, UK debt is coming off a low base. US debt, for example, went above 100% of GDP a while ago, while Japan’s debt is over 200% of GDP. Having said that, given the higher interest rates, this is not an ideal time for debt levels to be rising. The UK fiscus will also face additional challenges given that weak economic growth will reduce the value of tax collections, meaning that they will have to increasingly turn to the debt markets to fund any spending shortfalls. In turn, rising interest rates will put governments under pressure to service their debt.

What is concerning for the UK is that the country hasn’t seen peak inflation yet, which is illustrated by its core inflation increasing from 6.8% to 7.1% in the last quarter. Given this rising inflation, it is unlikely that the UK will cut or even pause rates any time soon. In June the BoE unexpectedly hiked rates by 50 basis points and we are expecting further hikes before the end of the year. The BoE has accepted that the UK is going to have to endure a recession to get inflation under control. This puts England right in the middle of the danger zone, which will see increased risk for consumers and for business.

In terms of UK growth, we expect it to be well-below-capacity for the next 12 months descending to 0.5% or lower. The economy should then recover and after three years we should be seeing growth of around 1.2%. Although above capacity, this is indicative of a bleak economic environment.

China – bucking the trend

Unlike other major economies, China is on the opposite side of the recessionary cycle, with the Chinese economy recovering following its Zero-COVID lockdowns. It does, however, appear that the economy is running out of steam due to a number of moving parts that drive the Chinese economy, including global demand. Despite growth not being what the Chinese government would like it to be, housing sentiment is holding up quite well. Households currently have improving income expectations, which is the opposite of what is happening in the West.

When you compare Chinese consumer spending to the West, which has seen a decline since last year, Chinese spending has increased by 18% from a year ago. The country’s tourism revenue, given a number of public holidays, has also increased rapidly to pre-COVID levels, proving that Chinese consumers are back in business, which will contribute to China’s more sustainable growth.

On the other side of the economy, manufacturing and industrial production is also elevated and continues to improve. Chinese exports are also improving, but we must remember that these numbers come off a really low base because China is coming out of COVID lockdowns. Supply chain conditions have improved from where they were during the lockdown phase and China had strong first quarter GDP on the back of increased consumer spending as consumers came out of lockdown. There has also been a ramp up in government infrastructure investments.

There are, however, some challenges, with the biggest being the country’s youth unemployment which has started to increase and currently sits at above 20%, which is high for China. This is due to the challenges the economy has faced but also because the economy is changing to become more consumer-based rather than export and manufacturing-based. This means that more youth are attending universities or studying. Next year it is expected that 12 million graduates will enter the job market. The problem is that China’s transition to a consumer-based economy is not happening quickly enough to absorb these graduates who are looking for white-collar jobs rather than the traditional blue-collar jobs. Adding to job shortages, deep globalisation has seen a number of manufacturing jobs move out of China to peripheral-Asia. So, despite its growth, China is going to need to manage these challenges.

We do, however, expect China to weather the storm. When it comes to growth, the country is expected to average around 5% over the next three years, with the next 12 months coming in higher than 5%, maybe rising to 5.5% before growth trails off to 4.5% in three years’ time. These are solid numbers for the world’s second largest economy, which should buffer the global slowdown somewhat.

South Africa – preparing for a hard landing

Given the state of the local economy, as well as a weak global environment, there is no way we see South Africa escaping a hard landing. The country’s structural issues, on top of global economic issues, means that we will go into recession over the next 12 to 18 months. But on the upside, the country will see a recovery, in line with global recovery, over the next two to three years. With promising projects and investments in the pipeline, growth might even surprise to the upside given current expectations. However, before there is any pickup, we need to brace for much tougher times.

Headwinds the country faces include much tighter monetary policy as the South African Reserve Bank (SARB) seriously looks to bring inflation down. In June SARB raised rates by 50 basis points, and we are expecting more hikes in the future as the Central Bank tries to get inflation to the mid-point of its target of 3% to 6%. In addition, continued loadshedding is expected to add to inflation. The SARB says that the cost to businesses of providing alternative energy sources has inadvertently fuelled local inflation numbers, adding as much as 0.5% to them. According to SARB stats, getting power from a generator is 133% more expensive that drawing power directly from the grid (if it is available!). In addition, there has also been a sharp rise in uncertainty around the political landscape, as our geopolitical relationship with Russia has resulted in discordant relations with the West.

Given these issues, South Africa’s leading indicator suggests that the country will experience no growth in 2023. The latest GDP print confirms this with only a 0.2% growth rate over the past 12 months. This is well below capacity, because South African population growth sits at around 1.5%, meaning the country is already in a recession. This, with the world potentially going into recession over the next twelve months, means our economy is in for a double whammy, almost guaranteeing that anticipated hard landing.

High unemployment, coupled with high inflation and high interest rates are also putting South African consumers under a lot of pressure and capping their spending potential, which is starting to impact retail sales. With less disposable income, consumers are also spending more on credit, which is a further challenge, given the increase in interest rates.

Adding to inflationary pressure is rand weakness, which is currently being politically driven. South Africa’s alignment with Russia and the Lady R saga around South Africa supplying arms to Russia caused the rand to plummet. This rand weakness will likely show up in our inflation numbers in the second half of 2023, meaning we are not out of the woods and SARB monetary policy is likely to remain tight. As such we expect more interest rate hikes well into the second half of the year.

This poor economic outlook and rand weakness is putting a lot of pressure on the Finance Ministry’s budget which was presented in February. Low growth will result in lower tax collections, which will be compounded by growing expenses like the government wage bill which, since Finance Minister, Enoch Godongwana’s budget speech, has gone up by R7 billion. So, the fiscus has massive headwinds, which will put added pressure on the rand and on the bond market.

However, it is not all bad news. If we look at what is happening on the ground, we realise that if South Africa can rebuild its stock of public infrastructure and improve public-private partnerships, the country can get itself back on the road to more inclusive growth. And that is starting to happen, but it is a slow process. If you look at South Africa’s J curve, it is much deeper than other economies, but with stronger public-private partnerships, we may then see a stronger uptick.

In the last quarter, President Cyril Ramaphosa hosted another investment conference. Investment pledges in the pipeline, since he has come into power, now sit at around R1.5 trillion, which exceed the R1.2 trillion that was initially targeted. But this is not assured investment yet. Foreign investors require the structural issues to be addressed faster and would only follow once local investors are returning.

Yet, there are already some signs of local investments turning up. At the last GDP print we had another positive quarter in terms of fixed capital formation, which brings us to six in a row. We haven’t seen that in decades. A clear sign that private and public companies are reinvesting back into the economy. A significant part of these investments is in the alternative energy space. This means that currently, we are on the way to solving the electricity problem – but not the Eskom problem, which is a separate issue. This is important, because when we look at fixed capital formation, we lost a lot of ground after 2009, especially to East Asian countries who are our peer group in this regard. We peaked at 20% of GDP, then bottomed out at 13% and we are now making our way back. If we are to achieve economic growth and job creation, we require improving returns on physical social infrastructure, while we leverage off private investments and improve the efficiency of public investments.

As we rebuild some of our public capital stock and create synergies between the public and private sectors, we are creating opportunities for faster growth, not this year, but in years to come.

When we sum up the country’s growth trajectory, we think we will flirt with 0% growth for the next 12 months, and then reach 1.5% the following year and if reforms continue, we may even reach 2% growth in three years’ time.

The rand – after a volatile start, it should settle by year-end

The rand is typically tied to South Africa’s economic outlook as well as global capital flows. However, over the last quarter, the rand has been more impacted by geopolitical factors. The Lady R controversy, saw the rand fall from the R18.50/$ to over R19.00/$ reaching nearly R20.00/$, which was weaker than when the COVID lockdowns started, and South Africa was downgraded to sub-investment grade. At the time, the rand plummeted to R19.35/$.

It is also important to remember that in addition to local factors, the rand will always reflect global factors including global capital flow, dollar strength, and China’s growth and demand for commodities. In addition, political risks, like our current environment of political uncertainty, not only impacted by our dealings with Russia, but also by the upcoming 2024 National Election, add to rand-weakness. During the year in which Jacob Zuma was forced out as president of the ANC and Cyril Ramaphosa took over, the rand experienced an extended period of weakness due to political uncertainty. We think the rand will remain under pressure given the uncertain political environment, at least until after the elections.

Despite the rand being under pressure, we are not in the game of being doomsday seers who predict the rand will reach R25.00/$. This is because we believe global factors will bring it down to stronger levels. As major economies like the US approach peak inflation, major currencies like the dollar will start to weaken as interest rate expectations are being adjusted downwards. As such, we think there is a good chance that the rand will strengthen and potentially reach the R17.50/$ level by the end of the year.

Investment – it will get tougher before it gets better.

Looking at the economic outlook for all regions of the globe, excluding China, we are in for a tough 12 to 18 months as we approach the bottom of the economic cycle. The impact of a recessionary environment will be different for every country, but we expect soft landings for developed economies, and probably a bit harder for emerging markets, including South Africa. China, however, does have the potential to cushion the blow, given their counter-cyclical stance at this point.

But it is a challenging growth environment in which markets and growth assets will face multiple headwinds. So , our view during this time is to remain cautious and defensive, as we go through this bottoming out of the cycle. In two or three years from now, as we move past peak inflation and peak interest rates, the upturn in the business cycle will bring some growth opportunities. Ultimately, while we remain cautious for the short to medium term, we will start making changes to the composition of portfolios to ensure that they benefit from the global uptick when the time comes.