South African Economy: What might go right? - October 2018
IT HAS BEEN a consistently disappointing year for growth. After a decade in which growth barely topped an average of 1.5%, accompanied by a grinding deterioration in political environment and institutional integrity, it wasn’t hard, arithmetically, to justify a sentiment driven reprieve this year. Indeed, at the start of this year, the drivers of growth seemed broadly in line. Global growth accelerated into the fourth quarter of 2017, domestic terms of trade were elevated, the US was set to deliver a decent taxpayer boost to already strong output activity, and low global inflation pointed to only a slow normalisation of very accommodative global monetary policy settings.
Then a number of things went wrong. Global growth momentum, especially in developed economies, slowed meaningfully in the first quarter of 2018. The US saw GDP moderate to 2.2% q/q saa from 2.3%, but in Germany growth slowed to 1.5% q/q saa from 2.2%, and Japan’s economy registered a contraction. Some of the slowing reflected one offs which reversed in the second quarter, but the disruption stalled the momentum which built through 2017. While global growth is still robust, it has become more uneven and, importantly, visible risks have increased. And they are all to the downside.
In South Africa, high frequency data was discouraging to start with: mining production contracted and manufacturing was weak, affected by refinery closure and other disruptions. Net trade fell hard in the first quarter, with an iron ore derailment at least in part to blame. Agriculture was much weaker than expected, affected by the drought, and a high base.
From an expenditure perspective, data for the first half of this year points to households under immense strain. Real household income has been under pressure since 2010. With the VAT hike, and another year in which there was effectively no adjustment for bracket creep, consumers have seen a meaningful increase in their tax burden relative to income. Household spending contracted 1.3% year on year (y/y) in the second quarter of 2018 off a low 1.0% y/y in the first quarter. In addition, gross fixed capital formation contracted for the second consecutive quarter as government and public corporation spending fell, offsetting a nascent recovery (albeit important) in private capex. The various supply side one offs led to a massive inventory contraction, which took an additional 2.9pps off GDP. Net trade was the only real positive, with a recovery in export volumes.
By mid-year, hopes of a speedy recovery were dashed. Output data have improved, but momentum is too slow, for now, to meet high hopes of a post Zuma recovery this year. It’s all taken a lot longer than expected.
As we head into 2019, it’s hard to be optimistic, because a number of things have now deteriorated:
- Global growth is slowing, and has become more uneven;
- Global trade volumes are under pressure and trade tensions have risen;
- Higher US interest rates, and possibly elsewhere in coming months, implies a more adverse environment for emerging market assets;
- High oil prices threaten inflation and reduce real incomes;
- Domestic policies remains messy despite the best efforts of the new administration;
- Domestic employment and wage data are still weak;
- Profitability is under pressure; and
- Sentiment has deteriorated.
While these developments make it hard to expect a meaningful acceleration in growth in South Africa, I still think the worst is behind us. So let’s indulge in a little sideways thinking. What could go right?
With South Africa having scored so many own goals in terms of policy and political rhetoric that negatively affected sentiment and growth and having suffered a number of ‘one offs’ which affected output, there is some merit to the argument that the country may benefit from stability in these areas. The economy, demonstrably, hasn’t grown. Without growth there is limited room for a deceleration - You can’t fall off a cliff if you haven’t climbed it! Growth is always a function of a combination of labour absorption (consumption), capex and productivity gains. In turn, consumption is a function of income growth and a willingness to spend, while capex usually requires a change in capacity constraints and an improvement in expected returns and is usually the biggest driver of efficiency (productivity).
The protracted period of economic malaise has seen deleveraging (except the state). There are few visible excesses and credit growth in real terms is low but stable. Importantly, consumers should see some easing in their very constrained positions in coming months. Most recent data suggest a modest acceleration in credit extension to households. Consumer confidence, which undoubtedly overshot in the first half of the year, remains elevated by historic standards and is historically consistent with stronger spending. Household leverage has declined, and debt service costs remain low. Household saving has turned positive, which suggests some cushion has been rebuilt. While higher fuel prices are a rising headwind, the rate of change should slow in early 2019, and we expect food inflation to remain reasonably low. Importantly, we do not expect a similar increase in household tax burden in 2019/20. The outlook for employment is stable, and it is possible that government’s infrastructure plan could improve employment at the margin. Similarly, the extension of the youth employment tax incentive should also help.
While gross fixed capital formation was very weak in the first half of 2018, private capex was positive. The available data shows companies have increased investment in non-residential structures and transport equipment, and recent data for building plans passed has visibly picked up. In addition, inventories, run down excessively in response to interrupted mining and manufacturing supply, have room to recover.
It is likely that a meaningful acceleration in domestic demand will push the current account deficit wider. It is also possible that the sharp depreciation in the currency and recent moves to simplify tourist visa requirements could facilitate a bumper tourism season in the year ahead. The currency may be vulnerable, but some offset is possible too, if we get just a few things right.
With this in mind, we expect growth to recover moderately in the third quarter and accelerate further into 2019. With a real growth forecast of 0.8% this year and 1.8% next year, the forecast still implies a relatively constrained acceleration and modest growth in 2019 only just at or slightly below potential. This not only implies a return to an uninspiring past, but also an environment in which core inflation should remain low. Our forecast for inflation is for CPI to average 4.6% in 2018 and rising to 5.4% in 2019 despite the weaker currency and acceleration in oil prices. In this context, we are unlikely to see an aggressive interest rate cycle, despite the risk that the SARB Monetary Policy Committee (MPC) may decide to moderately increase nominal rates as inflation ticks up. We expect real rates to remain accommodative. Our base case is for interest rates to remain on hold through mid-2019, acknowledging the risk that the MPC may opt to start gradually raising rates should rising headline inflation threaten long term expectations. It is, however, worth highlighting that within this relatively benign base case, considerably faster and more inclusive growth is needed to ensure fiscal and social stability.
What drives sentiment? More and more bad news has driven domestic sentiment weaker for a decade. While this year has certainly taught us that lost momentum and a deficit of trust takes more than we’d thought to heal and in turn translate into committed capital either by households or businesses, it is possible that, at the margin, the rate of deterioration has bottomed.