Painful healing lies ahead -- if we’re lucky

GLOBAL markets have traded relatively nervously over the past month as investors have had to contend with a bottoming in inflation in several key developed markets.

Headline inflation rates, driven by base effects and a stabilisation in commodity prices, have begun to increase in the US, Europe and the UK. Although inflation in developed markets is expected to rise gradually, the upturn has already begun to contribute towards higher bond yields in these economies.

Linked to the impact of rising inflation on bond yields in developed economies is the prospect of a reduction in monetary stimulus.

In the US, eurozone and Japan, bond yields were also pressured higher by an increasing likelihood that the US Fed would raise rates next month and by rumours that the European Central Bank had recently discussed tapering the quantity of its monthly asset purchases. The rise in developed-market long-term interest rates was expected to cause a reduction in the search for yield, putting pressure on emergingmarket currencies and rates.

This has been exacerbated by the potential asset-price implications of Donald Trump’s proposed economic policies. The risk-off environment triggered by the unexpected Trump victory has resulted in a notable selloff in emerging-market equities and currencies. The biggest loser has been the Mexican peso, which has depreciated to record lows on fears of protectionist trade policies.

Investors found refuge in gold and the Japanese yen, while US equities were lifted by expectations of higher earnings growth due to anticipated fiscal stimulus and the possibility of lower taxes and less regulation. Equity markets have stabilised, and emerging-market currencies have since recovered some of their losses. However, uncertainty remains on how Trump’s economic policies will affect the global economic outlook.

Locally, rand movements will be determined by international events unless the political climate heats up again. South Africa’s macroeconomic outlook remains subject to a large degree of political risk. Given the fluidity of the political environment, a meaningful shift in policy intent to implement growth-enhancing supply-side reforms is unlikely.

However, if South Africa does not suffer another political shock that causes foreign investors to strongly reduce their allocation to the country, the economy should continue to rebalance gradually.

This process, as necessary and painful as it is, will be characterised by weak domestic spending that, in turn, will reflect in low credit demand and mediocre GDP growth over the next couple of years. The payoff from this healing process should be a smaller and more manageable current account deficit.

The weak growth environment coupled with the positive impact of easing drought conditions on food prices will lead to a moderation in inflation. Inflation is likely to peak in December this year and moderate steadily over the course of next year, ending the year within the Reserve Bank’s target band.

Not only will falling inflation boost consumers’ real spending power, but it should also reduce pressure from domestic sources for the central bank to further hike interest rates.

Local assets also came under pressure following the medium-term budget policy statement. Although it proposes additional measures to increase revenue and cut costs, these are insufficient to fully offset the impact of weaker growth, resulting in slightly wider deficit projections.

In addition, the National Treasury’s growth forecasts remain above our own, implying there continues to be downside risk to these forecasts. The government’s debt levels are also now budgeted to be higher than those announced in the February budget due to weaker growth and an intention to increase cash balances via excess issuance, to protect against rising rollover risk.

The low-growth environment and worsening fiscal metrics increase the odds that, barring significant structural reform, South Africa’s sovereign rating will be downgraded within the next eight months.

Nxedlana is FNB chief economist