TRYING TIMES FOR SOUTH AFRICAN ECONOMY

In addition to the ongoing risk of Fed tightening, some new inflation pressures have emerged

Last year was a terrible one for the SA economy. GDP data to be released on March 7 will reveal just how bad.

The Reuters consensus is that growth will come in at just 0.4% — the economy’s worst performance since the 2009 recession — while employment growth and per capita GDP growth are expected to be negative for the year as a whole.

Last year, cyclical shocks, the drought and SA’s selfdestructive politics — as typified by the Hawks’ relentless pursuit of finance minister Pravin Gordhan — combined to bring growth to a standstill.

Consumers came under intense pressure. Thanks to the drought, real agricultural output contracted by double digits over the past two years. Food price inflation trebled in 2016, pushing inflation up to 7% and generating a 75 bps rise in interest rates over the year.

Amplifying the downswing was a further slowdown in capital expenditure. After four consecutive quarters of contraction, gross fixed capital formation remains deep in recession and unemployment at record highs.

KPMG economist Christie Viljoen warns that the weak performance of the mining and manufacturing sectors during the final quarter of 2016 suggests that SA likely posted GDP growth of little better than 0.5% y/y in the fourth quarter. This would yield an annual growth rate of 0.4% — well below most estimates at the start of 2016.

Both manufacturing and mining will have acted as a drag on fourth quarter GDP growth, with recent data showing that manufacturing production growth contracted by -1.1% q/q in the quarter and mining by -2.7% q/q.

For the year as a whole, mining production was down by 4.9% y/y, following an increase of 4.3% y/y in 2015, while manufacturing output recovered to a weak 0.8% y/y in 2016 from -0.1% y/y in 2015.

Agricultural activity is the main upside risk to the 2016 GDP forecast, according to Stanlib chief economist Kevin Lings. “Agricultural activity should be positive for the [fourth] quarter after a poor third quarter reading and twoyear decline, but it’s difficult to judge just how positive.”

Provided there is no worsening of the political backdrop, and SA continues to avoid further credit-rating downgrades, then the consensus is that the coming year is likely to bring a mild cyclical recovery to about 1.1% real GDP growth.

On March 16, the US Federal Reserve’s open market committee (FOMC) will conclude its second meeting of the year.

According to Federal funds futures contracts, the market is pricing in about two Fed hikes for the coming year with only a 24% probability of a hike at the March meeting, following the 25 bps increase in December. Thereafter, the odds of a May hike are 39%, rising to 67% in June, 82% by the September meeting and increasing cumulatively after that.

The Fed’s “dot plots” (the interest rate forecasts of individual FOMC members plotted as dots on a graph) suggest, however, that three hikes are likely this year. The market’s view and the dot plots have differed for quite some time.

Historically the dot plots have been “overly hawkish” and over time have tended to converge toward the market’s expectation, according to Mohammed Nalla, head of strategic research and global markets at Nedbank Corporate & Investment Banking.

At the start of 2016, for instance, the dot plots indicated that four hikes were on the cards over the course of that year, whereas only one hike

At the start of 2016, for instance, the dot plots indicated that four hikes were on the cards over the course of that year, whereas only one hike actually transpired

actually transpired.

Nalla expects just one Fed hike this year, probably in the third quarter, and for rates to remain flat thereafter, with the next move possibly pushed into early 2018. This is more dovish than the market consensus.

The risk to this view is that US inflation escalates materially but this is something Nalla sees as a potential risk for 2018 rather than the current year.

The latest US employment data suggests that while the economy is growing, inflation is not yet a cause for concern. Nonfarm payrolls rose by a healthy 227,000 jobs in January but wage growth remains contained. Over the past year, average hourly earnings have risen by just 2.5% in the US.

Lings believes the January employment data will encourage the Fed to keep its hiking profile modest. He’s expecting two hikes of 25 bps each — on June 14 and September 20.

“There remains the possibility of a hike on March 15,” he concedes, “but the Fed may decide to wait to see more fully the impact of [US president Donald] Trump on the US economy.”

Trump’s ascension to the White House and his promises of unbridled fiscal stimulus have created a more challenging environment for emerging markets, undermining hopes that rate cuts might be on the cards in SA this year.

Specifically, higher US long bond yields on expectations of tighter US monetary policy have caused capital outflows from emerging markets reminiscent of market reaction to the US “taper tantrum” in 2013.

While the rand has displayed some resilience of late, SA’s monetary policy committee (MPC) noted in January that risks to the rand could re- emerge at any stage.

The MPC will have had the benefit of the Fed’s March rates decision — and the rand’s reaction — when it concludes its next meeting on March 30.

Since the recent trough of 5% in 2013, the Reserve Bank has hiked the repo rate by 200 bps in response to broadening inflationary pressures. Last year, it imposed 75 bps of cumulative hikes, bringing the repo rate to 7%.

The Reuters consensus is that the repo rate will remain flat at 7% throughout 2017 with the first cut coming only in the first quarter of 2018.

In addition to the ongoing risk of Fed tightening, some new inflation pressures have emerged. These include the firming of oil prices in response to Opec’s recent agreement to cut output, and sticky domestic food prices despite improved rainfall in many drought-stricken areas.

The MPC revised up its inflation forecast accordingly in January. It now expects consumer inflation to fall back within the 3%-6% target band only in the fourth quarter of this year and to average 6.2% for the year, compared with 5.8% previously.

It adopted a hawkish tone at the January meeting, stating that while it still believes SA “may be near to the end of the hiking cycle”, the deterioration of the shorter-term outlook requires increased vigilance.

“I expect to see rates on hold for most if not all of this year,” says Nalla. “The upside inflation surprise in December coupled with some tail risks in food inflation emanating from higher meat prices and risks to grains from the army worm infestation will keep the Reserve Bank cautious.”

Lings also expects the Bank to keep rates on hold but remain fairly hawkish while it assesses a range of factors, including the impact of Trump’s victory on emerging economies and the risk that the SA economy fails to lift growth in 2017.

“The bank is also clearly mindful of the ongoing risk of a credit-rating downgrade, which may require a policy response,” he adds. “While we expect rates to remain on hold in the short to medium term, it is still premature to forecast that the next move in interest rates will be a cut.”

Other events to watch out for include the EU Summit on March 9-10 at which British PM Theresa May could trigger article 50, beginning Britain’s process of leaving the EU.

Also important is the Dutch general election on March 15, but only as a bellwether of the mood of European voters given the looming French election.