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Citation - First Quarter 2023



Maarten Ackerman
Chief Economist and Advisory Partner
Estimated reading time: 19 minutes 03 seconds

A harder landing…

As we enter the second quarter of the year, we find ourselves in a very uncertain and volatile environment. In the first edition of Citation for 2023 we looked at the key themes for the year. Three months on, peak inflation, peak interest rates and the peak dollar are all playing out on the global economic stage. However, cracks are appearing in the system. The strain in the banking system, in both the United States (US) and Europe, highlight the issues facing the global economy. This is not surprising, as you cannot expect central banks to normalise monetary policy as quickly as they did without some sort of fallout.

In our last edition, we also mentioned geo-political tensions as a major theme for 2023 and we are already seeing names like Russia, China, Taiwan, North Korea, and Iran coming to the fore. Unfortunately, South Africa is also being added to that list, given its unpopular relationship with Russia and China.

Despite these themes which suggest a degree of uncertainty, just three months ago, the Organization for Economic Cooperative Development’s World Economic Forum meeting in Davos saw participants express optimistic outlooks around the global economy. World leaders believed a global economic recession is very unlikely, and that advanced economies could even avoid one. They predicted that any potential slowdown was at least 18 months away. These views were based on assumptions on positive economic data coming out of the US and Europe going into the year, the reopening of the Chinese economy following its zero-COVID protocol, the US green infrastructure spend that will give a fiscal boost to the US economy, and the lower-than-expected energy cost for the European Union (EU), with much better-than-anticipated inventory levels.

Now, as we move into the second quarter, the outlook has changed, and analysts are predicting an increasing likelihood of a hard landing. The first warning sign that there are cracks appearing in the system was the potential banking crisis with the closure of Silicon Valley Bank (SVB) and the Credit Suisse saga. Following on from the crisis, the International Monetary Fund (IMF) published a report flagging the factors that may indicate that a global recession is imminent. They listed three red flags to take note of.

The first is the US property market. In the US, the rapid rate of interest rate increases has resulted in a significant slowdown in real estate activity. The passing of building plans and buying of new homes are under pressure, with figures here almost 20% lower than they were a year ago.
The second red flag is the appearance of cracks in the real economy, which goes hand in hand with liquidity issues in the banking sector. The closure of SVB and rescue of Credit Suisse are indicative that there is pain in the system. When we talk about cracks developing in the system, we must remember that interest rate hikes take about nine months to really take effect. Given the lag effect of rate hikes, the cracks that we are seeing now are expected to get wider in time – this is our proverbial canary in the coal mine.

The last indicator the IMF refers to, which is often the last domino to fall, is the job market. As other sectors in the economy start to slow down, like the property or real estate sectors, job losses become inevitable. So, although unemployment numbers are still healthy, the IMF is predicting that US unemployment will reach 4%-plus during the course of 2023, which is in line with a recessionary environment.

If we now look at Citadel’s Recession Scorecard that looks at 10 economic indicators, we believe the likelihood of a US recession within the next 12 to 18 months is more than 90%. This prediction is based on the fact that all of our indicators have deteriorated significantly over the last year, and there has been no improvement in any of them in the past quarter. The Citadel Recession Scorecard flags each indicator as green, yellow or red. Currently all 10 of them are flashing yellow or red. The biggest red flag for us is the US’s inverted yield curve, which is the difference between long- and short-term interest rates. On the other end of the scale, employment remains the weakest indicator on our scorecard, but as mentioned, employment is usually the last domino to fall. When that happens, a recession is almost guaranteed.

So, from an economic point of view, the Citadel Asset Management (CAM) team remains cautious and believes the global economy is in a slowdown phase. The only question left is how deep will that slowdown be? Given that central banks are committed to bringing down what is very sticky inflation, and that the cracks in the system are already starting to show, we must prepare ourselves for a difficult economic environment over the next few quarters.

Inflation headwinds turning…

While sticky inflation is one of the causes of the current situation, one positive is that we are seeing that the inflationary headwinds are turning. We believe we have reached peak inflation, and we are turning a corner – albeit slowly. It is still going to take the central banks a while to bring inflation down to their target levels.

Our argument around abating inflation headwinds is based on an observable drop in shipping costs, food prices, the cost of energy – the original culprits that caused high inflation levels. While these falling costs are not having a big enough impact on bringing down current rates of inflation, producer price inflation (PPI) numbers, which is inflation at the factory gate, have come down to within acceptable ranges, with many figures coming in close to where they were before the supply shocks experienced during the pandemic and the Russia-Ukraine war. This is an important positive sign because these numbers also work with a lag of several months before impacting consumer prices. As a result, inflation is on the road to getting closer to central banks’ target levels, which will then pave the way for a halt in interest rate hikes, and then ultimately a cut in rates. However, we only expect this to happen towards the back end of 2024.

The US – we expect below capacity growth for three years

Positives for the US economy are that despite US consumer sentiment being at a decade-low, US consumers are, in fact, in a better position compared to previous recessions, simply because they have paid back their debt. In addition, US employment is solid and despite higher mortgage rates, delinquency rates – where people stop paying back their mortgages – are still relatively low.

However, currently the negatives are outweighing any positives. The cost-of-living crisis in the US is hitting consumers hard, and we are seeing that consumer savings are dwindling, and people are once again increasing their credit card debt, just to make ends meet. This is a negative signal for the US economy, as it paves the way for problems in the future. Retail sales are significantly down from a year ago and have found themselves in negative territory, which is another signal that US consumers are struggling. This is concerning as the US is a consumer-based economy and more than 70% of US economic growth is consumer driven, meaning the US economy is likely entering an environment that will see a further growth slowdown. On the manufacturing side, all indicators suggest that we have not yet seen the bottom of the current slowdown. There is ongoing downward pressure in terms of manufacturing and industrial production. The property market is also soft and continues to adjust downward due to higher rates.

Given these challenges, we expect that this year, US economic growth will print significantly below capacity with a rate of just 0.9%, almost 50% below US capacity growth. We expect US growth to average around 1.2% for the next three years, which is still below capacity. This, however, is by design, as the US Federal Reserve (Fed) wants to keep growth under pressure, to cap demand, to bring inflation under control.

The EU – following in the US’s footprints

Like the US, the European Union’s (EU’s) leading indicators are depressed. Echoing US trends, EU consumer confidence is at its lowest levels in over a year, not because of job losses, but rather the cost-of-living crisis, as well as the geopolitical issues on its doorstep.

The EU’s outlook is in line with the US. Employment numbers remain strong, but this is not helping in terms of consumer spending, which remains weak. Consumers are cautious given the uncertain environment. Consumer debt is also starting to creep up, which indicates that EU consumers are looking for alternative ways to make ends meet. Production data in the EU is also stagnant, with Germany, the EU’s largest economy and production hub and a major global exporter of high-tech goods, a casualty, indicative of a global economic slowdown.

The view in Davos at the beginning of the year was that the US may go into recession, but that the EU may avoid a contraction. However, given the EU’s data, we believe that it is unlikely that the EU will dodge the bullet. While there may be a time difference of when recessions occur, the EU will, again, follow in the US’s footsteps. One big reason for this is that while Europe got through the winter with a much better energy supply than forecast, the German energy regulator has warned that there is a concern about how the EU will get through the next winter. This is especially true given its current inventory levels and the fact that the Russian oil and gas supply to Europe will be completely halted by then.

The EU’s inflation numbers are of great concern to the European Central Bank (ECB), which raised rates 50 basis points mid-March, and markets are expecting another 50 basis point hike at the ECB’s next meeting. This will mean the euro region will see a further 1% increase in rates this year, on top of what they had last year. The EU’s inflation is being driven by sticky food inflation and elevated inflation expectations. The ECB will therefore need to continue raising rates throughout the year, to bring its inflation down to more acceptable levels.

We expect economic growth to remain under pressure with only 1% average growth per annum over the next three years. The region’s capacity growth should ideally stand around 1.4%.

The UK – hitting a recession

While the United Kingdom (UK) has its own set of challenges, as it still tries to make Brexit work, it is also facing similar, if not worse numbers than the EU and US. The country’s consumer confidence is currently at a two-year low, which is being further amplified by fears that the economy will slip into a recession.

The UK’s PMI (Purchasing Managers’ Index) for private sector activity fell to 47 from close to 50 in December. Anything below 50 indicates that an economy is contracting. What is concerning for the UK, is that the rate of the decline is at its highest level since January 2021, when the UK was actually in full lockdown as a result of the COVID-19 pandemic. This highlights the enormity of the issues the country is facing. Company production output has also fallen at its fastest pace since the pandemic, which may explain historic consumer confidence lows.

On the back of poor economic data, the UK is seeing an increase in pay-related strike activity as households are under increased pressure to meet their costs of living requirements. The Bank of England (BoE) is currently the only central bank that is expecting a recession in 2023. So while the Fed, ECB and the Bank of Japan are speaking in terms of slowdowns and debating whether they are in for a soft or a hard landing, the BoE has pencilled in negative growth numbers for 2023. Politically, this puts the Conservative Party in a tricky position, as the party has a very short recovery period before the UK’s next general election in January 2025.

Other UK metrics are very similar to what we are seeing in the US and EU. Property prices are deflating, and mortgage approvals are falling due to higher interest rates. Consumer debt is also increasing, putting retail sales under strain. The country’s industrial production is also falling. But, despite this weak data, and regardless of the current cycle, UK unemployment remains strong.

So while the UK’s capacity growth is 1.5%, given the country’s current headwinds, Citadel’s thinking is in line with the BoE, in that we expect UK growth for 2023 to deliver, at the very best, a no-growth figure. We are then expecting the average growth for the next three years to be around 0.7%. This clearly indicates that fiscally, the UK is finding itself in a much tighter environment than the EU and US.

China – bucking global trends

Unlike other major economies, Chinese data is showing that China’s economic activity is rapidly returning to normal after dropping further zero-COVID controls. The Chinese government is predicting that its economy will recover to pre-COVID levels during the course of this year. Indeed, the government has provided plenty of additional stimulus to the economy to aid its recovery. In addition, indicators like mobility (public transport including flights)– and consumer spending are back on track, even though they are coming off a low base.

During 2022, the Chinese economy recorded a 3% growth rate. While, when compared to the global economy, 3% looks like a magical number, we need to remember that for a country like China, with capacity growth of close to 5%, last year’s growth number is well below par and, it could be argued, almost recessionary. But given the current environment, China is looking forward to a return of 6% growth for 2023 which is slightly higher that what we, at Citadel, are expecting. We believe that while China is the world’s second largest economy, it is not an economic island. Its growth is very much dependent on global trade, especially with the US, which is its largest trading partner. A weak US economy will undoubtedly impact China. So, we expect China to see growth numbers of around 5% on average for the next three years, which is indicative that the country’s economy is in recovery mode.

As the Chinese economy reaches capacity, it should underpin local demand, which supports the Government’s plan to get the Chinese consumer to play a bigger role in the economy. This should then have a knock-on effect and support imports needed to meet increased demand in the country. Other positives for the Chinese economy include a rebound in the housing market and the regulatory easing on tech and other industries.

South Africa – already in a recessionary environment

When it comes to South Africa (SA), the first quarter of 2023 was highly eventful. We started with Cyril Ramaphosa’s State of the Nation address, which was then forgotten on the back of our Minister of Finance, Enoch Godongwana’s Budget Speech. The budget was then overshadowed by Eskom Chief Executive Officer, Andre de Ruyter’s exposé on the extent of the corruption in Eskom. Hot on the heels of this news was Ramaphosa’s cabinet reshuffle, swiftly followed by the controversy of South Africa’s alliance with Russia and the country’s hosting of the BRICS (Brazil, Russia, India, China, South Africa) Conference in August, and the question of whether Putin will be in attendance. Finally, we saw the implementation of the National State of Disaster around Eskom – which has since been rescinded. All of this has provided a very unsettling environment for the country.

Back to the budget – the numbers that formed the basis of the budget were based on SA achieving positive economic growth this year, much higher than consensus. Now, two months on from the budget, those numbers are requiring a rethink, with even Godongwana saying that the numbers need to be reconsidered, given the amount of loadshedding we are experiencing, its economic impact on the economy and the over-budget wage demands of trade unions. All of these challenges are putting enormous strain on South Africa’s fiscal framework.

On the back of a poor global economic outlook and serious structural issues hampering growth in the country, South African consumers are finding themselves under severe pressure. The average South African is facing lower take-home pay, high unemployment – ours is the third highest in the world – high inflation, and rapidly increasing interest rates. Despite these pressures on the consumer, the South African Reserve Bank (SARB), took a very bold decision at the end of March, when it hiked rates further by an unexpected 50 basis points. This is counter to the rest of the world where central banks have started to reduce the size of their hikes.

In fact, the economic conditions in the rest of the world have deteriorated even further in the last three months and are also knocking our local economy. As such, our leading indicators suggest very weak growth for the country, pointing to a slowing down, or even a contraction. Looking back to 2022, SA experienced good growth, but that was largely driven by the agricultural sector –quite a small sector for South Africa – and exports, mainly of commodities. However, the sectors that should be driving the economy, namely mining, construction, electricity generation, and manufacturing, haven’t seen growth but rather have all declined. These are big sectors which create jobs for the country’s current skill base, suggesting that the growth SA saw in 2022, is not sustainable. This means that South Africa is experiencing a very unbalanced growth environment because the important sectors are not pulling their weight.

As such, the fourth quarter of 2022 came in with negative growth numbers, fuelled by the country’s record number of days of loadshedding. Considering the size of the economy at the end of 2022, it is now smaller than it was pre-COVID. This indicates just how challenging the current environment is, because most other countries are already back to pre-COVID levels and are growing from that base. SA, however, finds itself where it was in 2018, which ultimately equates to no growth for four years.

Added to poor fourth quarter performance, we are expecting a further negative growth figure for the first quarter of 2023. All of SA’s high-frequency data supports this assumption, including retail sales, mining, manufacturing and exports. This is as a result of all the structural issues facing the local economy and the fact the first quarter of 2023 saw the highest level of loadshedding in the country’s history. Given these headwinds, we believe that South Africa is already in a recessionary environment.

In this no-growth environment, unemployment will be neglected, leading to increased tension in terms of social deliverables. That is why the budget prioritised populace policies, which look after the country’s most marginalised people, like extending social grants and providing some inflation adjustment, while still trying to address the structural issues hampering the country’s necessary growth.

Tackling Eskom and the loadshedding, as well Transnet, which covers the ports and the country’s railway network, must remain government priorities. Until these issues are resolved, we will not see a turnaround in the country’s growth outlook.

Although over the last three years, South Africa has benefitted from a positive current account deficit, we have now printed a 0.5% of GDP deficit. This is being driven by increased imports which includes diesel to run Eskom’s turbines and then a fall in exports due to loadshedding and logistics issues associated with the harbours and rail. The slowing global economy has also impacted South Africa’s exports. The SARB, at its latest Monetary Policy Committee meeting, said that it expects this figure to grow to 3% of GDP over the next three years.

But there is some good news on the horizon. SA has now had five consecutive quarters of foreign fixed capital formation as a percentage of our GDP, something we haven’t seen for a very long time. This is good news because it speaks to increased collaboration between the government and the private sector as companies reinvest back into the economy and paves the way for more sustainable future growth. A large chunk of these investments are into the renewable energy sector, which is positive as it addresses Eskom’s structural issues and can help South Africa to accelerate its economic growth. For example, the number of embedded projects that were registered with the National Energy Regulator (NERSA) jumped significantly in December last year and now exceeds 350 MW of generating power. If you look at all the embedded generating power that is currently in the pipeline, from the mining sector, chemical sectors, energy developers, data centres, municipalities, and private households, we are talking of a potential 9500 MW of power being brought online over the next 18 months. While it will take some time to see the results with loadshedding prevailing for now, these projects will address some of the daily issues we face, bolstering business and economic growth.

To sum up, most analysts are predicting no growth for SA in 2023. Citadel predicts that growth will fall between 0% and 0.5%, which is insufficient given that our population growth sits at around 1.5%. But we expect this number to pick up and for growth to average at 1.2% over the next three years as some of the structural issues get resolved.

A battered rand

The South African rand experienced a number of headwinds over the last quarter. The country’s current account deficit has seen the country pay more in foreign currency to secure its imports, placing the local currency under pressure. Adding to the local conditions, global liquidity is also drying up as we see cracks developing in larger economies. It is very possible that we will see the rand get even weaker from its current levels, especially given global inflation issues and rising interest rates. Only when rates start to normalise, which we expect in the second half of the year, will the dollar come under renewed pressure, and possibly boost the rand.

Yet the low growth outlook for South Africa compounds the strain on the rand. A no-growth outlook will result in the South African Revenue Service not being able to meet its tax collection targets, meaning Treasury will need to access the debt markets and borrow again, which will increase the country’s debt-to-GDP ratios, which again, will negatively impact the local currency.

Investment Focus

While I refer you to Harold Strydom’s analysis of Citadel’s asset class views during these volatile times, I will note that Citadel Asset Management’s view is that, given the bleak economic outlook locally and globally, 2023 is going to be a tough year.

Increased interest rates and the cracks in the financial system will put growth assets, like equities, under pressure. So, from an investment point of view, Citadel remains cautious, and will make sure that there is sufficient protection built into its portfolios to carry our clients through this kind of uncertain and volatile environment.