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Standpoint: Global Reflation by Kevin Lings
- 1. stanlib.com STANLIB is anauthorised financial service provider. GLOBAL REFLATION - THE IMPACT ON THE SOUTH AFRICAN ECONOMY AND ASSET CLASSES Deflation risk During the 18 month period from the beginning of 2015 to the middle of 2016, many financial market participants, financial analysts, as well as central bank policy officials, became increasingly concerned about the risk of outright deflation, especially in the developed world. For example, consumer inflation in the United States averaged a mere 0.1% during 2015 versus a 20-year average of 2.2%. Similarly, Euro-area consumer inflation was measured at only 0.01% in 2015, compared with their 20-year average of 1.75%. At the same time economic growth remained below trend, with little sign of accelerating. In fact, during 2016, the United States achieved a growth rate of only 1.6%, while the Euro- area was up 1.7% versus long-term averages above 2%. This risk of sustained deflation was accompanied by continued record- low interest rates, an ongoing commitment by central banks to maintain Quantitative Easing (QE), exceptionally low bond yields (with negative government bond yields recorded in many European countries including Germany and Switzerland), and talk about the need for central banks to introduce “helicopter” money. “Helicopter” money being the free distribution of printed money by the government directly to the public in order to encourage increased spending. Some analysts feared that Europe would enter a sustained period of deflation and stagnant growth similar to that experienced in Japan over the past twenty years. Fortunately, all of this has now changed. Consumer inflation within the group of 34 advanced economies has risen fairly quickly to an average of 1.9% year-on-year in SOME ANALYSTS FEARED THAT EUROPE WOULD ENTER A SUSTAINED PERIOD OF DEFLATION AND STAGNANT GROWTH SIMILAR TO THAT EXPERIENCED IN JAPAN OVER THE PAST TWENTY YEARS. Consumer inflation in developed markets Source: STANLIB, Bloomberg 0.0 0.4 0.8 1.2 1.6 2.0 2013 2014 2015 2016 2017 Ave 1.8% since 2000 %y/y Fears of sustained deflation and stagnant growth in the United States and Europe have been replaced by a more optimistic growth outlook as well as concerns about rising inflation. This has driven developed market equities higher, but also weakened major bond markets. By Kevin Lings STANLIB Chief Economist
- 2. stanlib.comSTANLIB is anauthorised financial service provider. January 2017, which is slightly above the 20-year average of 1.8% and well above the recent low of less than 0.1% in late 2015. In particular, US consumer inflation is up at 2.5% in January 2017, while the inflation rate in the Euro- area is back to the target level of 2%. Unsurprisingly, talk about “helicopter” money has evaporated, and the US Federal Reserve has hiked rates by a further 25bps with a clear intention to increase rates further in 2017. Many analysts have also suggested that the European Central Bank (ECB) will soon have to discuss tapering QE. This sharp turnaround in developed market inflation has pushed government bond yields higher. In particular, the yield on the US government benchmark 10-year government bond has risen from a low of just below 1.6% at the end of September 2016 to around 2.5% at the end of February 2017, while the German 10- year government bond yield has jumped from -0.12% in early September 2016 to over 0.3%. Similar trends have unfolded in many other advanced economies. There has also been an uptick in global equity markets, despite ongoing concerns about high valuations. For example, the S&P 500 equity index has risen by 22% over the year to end February 2017, having gained more than 11% since President Trump was elected in early November 2016. What is driving reflation? The catalyst for this switch away from concerns about outright deflation to questions about higher inflation has been a combination of two key factors. Firstly, there has emerged a slightly more optimistic outlook for the global economy. This has, to some extent, been focused on the United States and the expectation that President Trump will follow-through with his election promise to lift economic growth closer to 4% and stimulate further job creation. Secondly, noticeably higher oil and commodity prices, which have been partly supported by increased fiscal stimulus in China. For example, the oil price moved from a low of around $30/barrel in January 2016 to $54/barrel in January 2017, an increase of 77%. There has also been a noticeable increase in a broad range of industrial commodity prices, while global food inflation has also moved higher. While there was broad consensus last year that commodity prices could increase meaningfully, especially after it became clear that China was intent on providing further fiscal stimulus in the form of fixed investment spending, financial market participants remain sharply divided about the impact of Trump’s presidency on the US economy. Trump’s impact on US economy Irrespective of one’s view of Trump, there is no denying that US business confidence has risen sharply since Donald Trump was US leading indicator vs ISM Index 33 38 43 48 53 58 63 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 -20 -16 -12 -8 -4 0 4 8 12 16 % y/y % y/y Leading Indicator (RHS) ISM manufacturing (LHS) ISM index tends to lead the leading indicator Source: STANLIB, Bloomberg THE S&P 500 EQUITY INDEX HAS RISEN BY 22% OVER THE YEAR TO END FEBRUARY 2017 Euro-area consumer inflation Source: STANLIB, Bloomberg % -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 2010 2011 2012 2013 2014 2015 2016 2017 Euro-area
- 3. stanlib.comSTANLIB is anauthorised financial service provider. elected President of the United States. In addition, it is clear that the boost in US business confidence is linked to Trump’s promises regarding corporate tax cuts, reduced business regulation, greater trade protection and increased spend on economic infrastructure. This improvement in confidence is especially noticeable in the optimism of the small business sector as well as ISM manufacturing index. Overall, the US is experiencing its highest level of business and consumer confidence since before the global financial market crisis in 2008/2009, and is clearly much more confident after the election of Trump. Importantly there is a strong and positive correlation between US confidence and economic growth. Hence a sustained rise in business confidence should lead to a noticeable improvement in US GDP growth. This potential reflation of the US economy has been encouraging equity markets higher, especially in the developed world, despite demanding valuations. Lastly, while the commodity price increases, mentioned earlier, have pushed headline inflation sharply higher, there is still no indication of a broad-based acceleration in core, or underlying inflation in the United States and Euro- area. For example, US core inflation appears relatively stable at just over 2%, while core inflation in the Euro- area remains slightly below 1%. This does not mean that core inflation will not start to gain significant upward momentum, but such a move is most likely going to have to be accompanied by a more rapid increase in wages in an environment of accelerating economic growth. US wage growth was last recorded at a mere 2.5%y/y, which is probably not robust enough to raise significant concerns about sustained higher inflation; but is worth watching. US fixed-interest markets appear to be priced for a near normalisation of consumer inflation around its long-term average, and a modest, but slow, rise in official interest rates. While this still seems to be a fair base-case assumption, we will continue to closely monitor the upside and downside risks to core consumer inflation in the major economies as these risks have become a lot more pronounced in recent months and could unsettle financial markets, especially the bond market. Impact on South Africa The impact of all of this on emerging economies, such as South Africa, is much more uncertain. In general, as the US continues to normalise interest rates on the back of higher inflation and an improved growth outlook, investments would US small business outlook over next 6 months Source: STANLIB, Bloomberg Index -40 -30 -20 -10 0 10 20 30 40 50 60 04 05 06 07 08 09 10 11 12 13 14 15 16 17 US consumer confidence Source: STANLIB, Bloomberg Index 20 40 60 80 100 120 04 05 06 07 08 09 10 11 12 13 14 15 16 17
- 4. stanlib.comSTANLIB is anauthorised financial service provider. be expected to flow away from emerging economies and back into the developed markets, especially the United States. This rather simplistic view of international capital flows is clouded by a number of key factors. Firstly, the dollar is fundamentally over-valued, while the euro is under- valued. This may encourage capital flows into the Euro-area, especially if the upcoming elections in Netherlands, France and Germany result in Europe recommitting to keep the European Union together. Secondly, the uplift in commodity prices is encouraging investment flows into commodity currencies such as the rand, helped by a slightly improved growth outlook. Thirdly, some emerging economies, such as India, Indonesia and Brazil have been cutting interest rates, while others such as South Africa and Turkey have been in a rate hiking cycle. All these factors suggest that the investment prospects in emerging economies have to be assessed on a country- by-country basis, and not necessarily as a collective group of countries. It is also clear that South Africa is in a slightly better position in that economic growth is expected to improve, albeit marginally. Some other signs of improvement are beginning to show: • The credit rating agencies welcomed the National Budget in February 2017 • The country’s trade balance has swung from a perpetual deficit to a more consistent surplus • The currency is still relatively under-valued despite its recent strength and interest rates have risen by 200bps from the recent low, offering investors a positive real return THE KEY UNKNOWNS REMAIN THE BROAD POLITICAL ENVIRONMENT COUPLED WITH RISING SOCIAL TENSION THAT COULD EASILY LEAD TO INCREASED INVESTOR UNCERTAINTY AND POSSIBLE RAND WEAKNESS.