Investment Environment February 2016

09.03.16

The world is split economically between Emerging Markets where growth has significantly declined to the extent of disappointment as they are meaningful contributors (40%) to the global growth rate. Equally disappointing is the Developed Markets growth rate, notwithstanding significant central bank stimulus which is well below the long term average of 3% since 2010.

The beacon of hope is the US GDP which is tracking a “new normal” of 2.5% per annum. The growth is supported by positive consumer spending probably helped by the lower US gasoline price and encouraged by government spending since mid-2014. 

However, the strength of the US dollar from early 2015 and slow down of industrial production, possibly influenced by the weak oil market, is negative for US growth. 

Oil is an important sector of the US economy and the graph below shows the marginal cost (cash cost) of producing a barrel of oil. This tells the story that only Opec members, Russia and Kazakhstan are able to produce at <USD30 per barrel. This might lend some credibility to the conspiracy theory that these producers are targeting the US and Canada’s oil, sands and shale production in making them unprofitable as indicated by the Oil Rig Count. However, it is not sustainable as the economic effect on these low cost producing economies is dramatic and for fiscal reasons oil prices will have to normalise (estimate Brent Crude +/- $60). How long this “stand-off” can last is questionable and while a higher price is a good measure of improved economic activity subdued energy costs are beneficial to the consumer. Oil needs to reach a finely balanced price point.

All eyes are on the FED who based on the US economic growth and core inflation has signalled a change in direction of interest rates with a 0.25% increase in December 2015. The question remains how sensitive Yellen and her colleagues will be to the remainder of the world that is struggling with no or low growth.

The Chinese GDP data has sent negative signals to the world and a great deal of concern arises due to the declining growth and weak Yuan. However, it is a known fact, as stated by Chinese authorities they are in the process of rebalancing the economy away from manufacturing and export towards consumption and services. It is important to note that this is not a cycle but rather an economic shift and while it can be argued that, manufacturing will slow and therefore commodity and energy offtakes will decline, the Purchasing Manager Index (PMI) indicators are not showing little evidence of a sharp slowdown.

There remains no doubt that China is a significant consumer of commodities and if the Chinese economy actually slowed dramatically this will continue to severely affect resource economies such as South Africa.

South Africa is endangered by recession and the potential of a credit downgrade. The situation has been put firmly in the hands of the new (recurring) finance minister Pravin Gordhan who has additional problems of drought, potential inflation and the necessity to cap government debt as a demonstration of fiscal discipline. Gordhans’s budget in late February forecast GDP growth for 2016 at 0.9% which, if backed by fiscal discipline in actual practice, it might be the initial steps to avoiding a credit downgrade.

However, in spite of Gordhan’s efforts, the political back drop needs to be conducive to stimulate business confidence (and consumer confidence) which needs to cause fixed private sector investment spending off the strong corporate balance sheets. Such activity will improve economic growth which is required by rating agencies. If these events can come together not only will a credit downgrade be averted, but South African economic growth will attract foreign flows of funds which will strengthen the ZAR. Unfortunately, the converse is also true and political shenanigans similar to those of 9/12 will derail these economic prospects and a credit downgrade will be inevitable. This latter scenario is partly priced in the ZAR and bond markets.

Conclusion

South Africa is on a political knife edge and the recent track record makes investors dubious of a positive outcome. DI continue to recommend hedging out of South Africa by continuing to use USD (or forex) allowances to invest abroad, and to the extent this is not possible, local portfolios should continue to be invested in developed market equity index trackers or rand hedge listed stocks.  This is nothing new and DI will only change this advice if the SA economy prevails over the political shenanigans experienced to date.  

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