By Francois van der Merwe, head of offshore investments at Novare, analyses world economic outlook after the second quarter of 2016.
The unexpected decision by the UK to end its 43-year membership with the European Union sent shockwaves through financial markets worldwide, sparking uncertainty with investors. However, the central banks pledge to ring-fence the crisis assisted in boosting confidence and most markets managed to recoil towards the end of the quarter.
The US economy did see some positive momentum during the quarter, with GDP growth continuing throughout the first quarter of the year and indicators remaining strong into the second. Retail sales soared, on the back of increased consumer confidence. Consumer price inflation saw its largest month-on-month increase in more than three years, rising by 1,1% compared to the previous year. This rise continued throughout the quarter, rising by 2,3% year-on-year by the end of June.
At the start of the quarter, the European market saw an increase in manufacturing activity and a decrease in unemployment, and both business and consumer confidence indicators remained upbeat. However, the Brexit raised questions around the strength of the EU. The European Central Bank and the Bank of England were quick to respond to the referendum and remained committed to their responsibility for monetary and financial stability. While this seemed to ring-fence the financial contagion, it also pushed developed market government bond yields lower.
During the second quarter the Chinese economy stabilised, with a GDP ahead of market expectations and governments growth targets. The improvement, however, was not reflected in fixed assets, which moderated.
Emerging market equities experienced a strong recovery in June, but it was not enough to push the MSCI Emerging Market Equity Index into the green and instead, the Index closed 0,3% lower during the quarter.
Within developed markets, the S&P 500 Index closed 1,9% higher and the FTSE 100 Index was up 5,3%. The Japanese Nikkei Index suffered a 7% decline on the back of a stronger yen.
It was a strong quarter for commodity prices, with gold up 7,2% during the quarter and the price of Brent oil surging by 25% on the back of unplanned supply outages in Canada and Nigeria.
South Africa once again managed to avoid a credit rating downgrade into possible junk status, and teetered on the brink of recession in the second quarter of the year. Local politics remained in the limelight ahead of the upcoming municipal elections, paired with concerns around Finance Minister Pravin Gordhan’s position. Despite political turmoil and renewed currency volatility in the light of international developments, foreign investors flocked to purchase local assets, and were significant buyers of local bonds in April and June.
Local GDP data reflected an unexpectedly large contraction in the first quarter of the year, mainly driven by challenges within the agricultural and mining sectors. This signalled the first year-on-year decline since 2009. Mining activity remained muted during the second quarter, negatively impacting on trade. Manufacturing activity improved slightly, owing to more competitive exports.
The low-growth environment remains worrisome, with credit ratings agencies having expressed concern around poor growth outlooks and political tensions.
South Africa’s weak economic growth was compounded by a deteriorating employment backdrop and increased unemployment, with construction, manufacturing and trade experiencing the largest job losses. Consumer confidence plummeted to record lows during the quarter and business confidence tumbled to a new, post-recession low.
The resources sector was the best performing throughout the quarter, with a return of 6,5%. The best performing sector since the start of the year was gold mining with a gain of 124,5% and a return of 16,5% for the quarter. Resource shares were up 20,5% for the year to date, while industrial and financial shares were in negative territory.
However, there was some relief in terms of inflation, owing largely to muted foreign exchange pass-through effects and lower food-price inflation.
The rand was volatile throughout the quarter, depreciating sharply in May, along with other emerging market currencies. The currency was also weighed down by the current account deficit. The STSE/JSE All Share Index ended the quarter relatively flat.
The rand’s depreciation of 0,3% for the quarter saw harsh fluctuations against the dollar, while it appreciated 76,3% against the pound to trade below the R20 level. Overall, the rand was one of the best performing emerging market currencies for the quarter and the year-to-date.
As we move into the third quarter, we remain in a low-growth global recovery where investors are deprived of yield-enhancing investments and the effectiveness of central bank monetary policies are being questioned.
While Brexit may have occupied the news headlines lately, it is the US Fed that dictates global monetary conditions and China that determines the marginal changes to world economic growth, and hold the key for the performance of global financial markets. The good news is that both are looking relatively positive – US economic data is recovering and the Chinese economy seems to have stabilised.
The uncertainty brought about by and surrounding Brexit should not be ignored. It will continue to impact future UK investment spending plans and commitments, as the vote has set the UK on a path towards recession. While the effects of a UK recession on global growth will be minimal, geopolitical risk remains a concern.
Europe is a main contributor in ensuring that global growth continues to recover, and sentiment indicators need to be closely monitored. Strong global growth over the coming months is unexpected and with profit margins already high, it is unlikely that that company earnings will be extraordinarily strong. This is expected to lead to below-average developed market stock returns.
Emerging markets have the opportunity to outperform developed markets over the coming 12 months.
Investors’ search for yield and return is expected to drive them up the credit risk spectrum into corporate and emerging market bonds.
Over the very short-term, investors should keep a cautious investment stance until there is clarity over the Eurozone economy and whether policymakers will be successful in ring-fencing the fallout from Brexit. Possible spillovers from the UK referendum to leave Europe could impact the global trade cycle, in turn, increasing the risks of a global recession.
Locally, we remain bearish about the outlook for the South African economy. The pace of economic activity is too low to reduce the incredibly high unemployment rate. Poor employment, high interest rates and price inflation will adversely affect household spending and put the consumer under pressure. While it might not be qualified or made official, it will feel like the country is indeed in a recession.
Stagnant economic growth and uncomfortably high inflation is a toxic combination for the South African Reserve Bank. Improvements on state-owned enterprises will be key for government expenditure and performance. Failing this may prove to be an additional hindrance for the economy.
Much of the company earnings growth will be dependent on what happens with the rand hedge stocks and resources shares. We are underweight equities in a balanced portfolio.
In terms of the bond market, we remain worried about the rand and that recent currency appreciation will not be maintained. We are underweight bonds and overweight cash.
Essentially, the global backdrop is rife with uncertainty, and volatility is here to stay for the foreseeable future. We continue to believe that maximum offshore exposure is necessary to take advantage of potential rand weakness as well as diversification purposes. To benefit from future market conditions, investors will have to follow an active investment approach.