BoE believes the United States economy’s dramatic growth spurt is coming to an end Anet Ahern The global economy has continued to recover in the last quarter, but signs are emerging that world growth is beginning to peak. Global leading economic indicators are topping out, and there are initial signs of a slowdown in the booming United States economy.
One key area where growth may still accelerate is Japan. The Bank of Japan (BOJ) is already signaling to markets that it is keen to end its zero interest rate policy, and a BOJ rate increase in the third quarter is likely. Signs of economic recovery are also evident in most emerging market economies, including South Africa. Real gross domestic product growth in “Euroland” is now above 3%, but leading indicators and a less accommodative monetary policy insurance from the European Central Bank (ECB) suggest that growth will peak at between 3% and 3,5%. The ECB is likely to raise rates another 25 to 50 points (a point is 0,01%) before year-end. The United Kingdom economy has shown clear signs of coming off the boil recently, and this has enabled the Bank of England to put rates on hold for several months. There is some risk that the BOJ may be too hasty in raising rates, but the principal threat to global recovery remains the still-growing imbalances in the US economy. In the face of these imbalances – extreme equity market valuations, rapid growth in private sector debt, massive and rapidly growing current account deficits, and now rising “core” inflation – the Federal Reserve Bank will have no option but to raise short-term rates further. Federal Open Markets Committee chair Alan Greenspan appears to be resisting these pressures but a major tightening of US monetary policy is nevertheless underway. In these circumstances a severe and prolonged correction in the US equity market is highly probable. A combination of rising interest rates and falling equity prices, in what is now a highly leveraged economy, will, at best, cause a significant slowdown in the US by 2001 with the danger of an outright recession rising. A US hard landing will almost certainly be accompanied by a much weaker US dollar. Key uncertainties for investors are thus how sharp the US slowdown proves, and whether recovery in the rest of the world is robust enough to withstand US setbacks. Our assessment is that recovery outside the US is fairly robust, but we remain concerned about the outlook for commodity prices next year. One crucial factor for global investors to recognise is that the share prices of many companies have already at least partly discounted these uncertain prospects.
A “bubble” in technology stocks and the big index stocks has driven the powerful performance of the major stock market indices in recent years. The gap in valuations between market high fliers and many neglected quality companies has closed in recent months but remains unsustainably wide, providing important stockpicking opportunities.
South Africa appears to be in the early stages of an economic upswing. The signs include higher export volumes, rising money growth, and a turn in the inventory cycle. Thus far the upswing is moderate and hopes for growth of 4% plus over the next two years are now too optimistic. Growth is being held back by the (necessary) rate “pause” imposed by the Reserve Bank, and fears (unfounded in our view) of future rate hikes. Interest rates remain uncomfortably high given the prospect of a fall in inflation. Growth prospects are also clouded by fears of a “hard” landing in the US and a downturn in commodity prices. However, it would be wrong for investors to become too gloomy about economic prospects. Although the rand has fallen sharply against the US dollar, the depreciation has been moderated by its effects on trade, and has helped protect the economy from negative external developments. The oil-gold combination may turn favourable for South Africa in coming months, as a weak dollar supports the gold price, while global slowdown reduces the oil price. The prevailing cautious attitude to private sector debt tends to reinforce the prospect that the “core” inflation rate will fall into the target range of 3% to 6% over the next year. The recovery is very much private sector driven, with state consumption spending falling sharply. The Reserve Bank may thus be in a position to reduce interest rates late this year or in 2001. South Africa may still achieve 3 to 3,5% growth this year (as the Ministry of Finance is predicting) and next year, even given a significant global slowdown. Weak equity prices induced by a global market downturn may then provide buying opportunities, while South African bond yields around the 14% level offer solid value.
Three of the major factors influencing our equity market, namely currencies, the interest rate outlook and turmoil in international markets, made themselves felt on the Johannesburg Stock Exchange during the past quarter. The equity market declined, retracing the gains in the first quarter and more. We still view the outlook for developed markets with some concern. However, our interest rate outlook, the improved outlook for earnings and the fact that the rand is now substantially weaker, lead us to conclude that the coming months are likely to provide a great long-term buying opportunity for South African shares.
Our equity market is not expensive when viewed on a price-earnings basis (PE ratio), particularly when one strips out the Resource sector (with what we perceived to be peak earnings over the next 18 months) and the TMT (technology, media and telecoms) sector, which pushes up the aggregate PE of the market. Earnings growth for the rest of the market is likely to be unexciting, but so is the price that many shares are demanding at the moment.
South African bonds delivered a stronger performance this quarter, returning 3% relative to the 1,7% of the first quarter. The R153 13% 2010 bond started the quarter at 14,1% after reaching a low of 13,1% in January.
Foreign selling, which totals R15,7-billion year-to-date, did not abate early in the quarter as nervousness over Zimbabwe intensified. The currency weakened to R7,20 to the dollar and bond yields peaked above 15,3%.
More recent inflation, trade, money supply and credit extension data has been supportive of the bond market and assisted in a rally to the current levels of 13,6%. We remain positive on the outlook for the bond market over the next 12 months. As oil prices start falling, increases in international rates abate and domestic inflation begins to slow, we see scope for short-term rates to come down. This will support the bond market further. Anet Ahern is chief economist at BoE Asset Management