Our second Fireside Chat between Avinash Kalkapersad, Head of Global Markets Research, and Walter De Wet, Senior Strategy Analyst, looked at the domestic economy, foreign exchange and interest rates. Walter joined Nedbank in 2017 and he leads our macro research offerings. He has made great strides in bringing together a coherent product offering. He has over 10 years’ experience as a macroeconomic strategist within the global market environment. His focus is on macroeconomic modelling, commodities, fixed income and foreign exchange markets.
Walter touched on three important topics which are: South Africa’s growth trajectory, the rand and what SARB should do next.
South Africa’s Growth Trajectory:
Walter recently downgraded his growth expectation for South Africa’s GDP. In an environment like this, where the world hasn’t experienced anything like this in the past – it is difficult to expect growth. A forecast into the future relies heavily on looking back by doing regression type analysis. Whether you build an actual model or do a relative comparison, it is based on history.
The South African Reserve Bank (SARB) announced that there is massive forecast error potential. Potential forecast error on inflation and growth, especially. Which leaves us in a poor position as we essentially do not know what is going to happen. There are different ways to forecast and one of the specific ways that we forecast is from a demand-side of the economy. We forecast on what we think the consumer, the government and the economy is going to do. We have to make assumptions on how we think income growth will be affected by Covid-19.
Initial assumptions at the start of Covid-19.
We made informed assumptions based on previous cases in history with needed adjustments. Initially, in April, at the start of the hard lockdown of four weeks we assumed that growth was probably going to fall by around 5% in 2020. That was the best-case assumption based on a hard lockdown of four weeks which was in reality five weeks when it was announced. However, lockdown was further extended and in reality the hard lockdown lasted eight weeks.
The second scenario was an eight-week severe disruption to the economy and a return to normal in Q4. On that assumption, we predicted a contraction of 7% in line with the current consensus and with what SARB has already said. Unfortunately, the global environment is currently experiencing second waves and it is clear to see that South Africa, like the rest of the world, is unlikely to return to normal in Q4. The outlook is that these lockdowns and restrictions will extend further into 2021 and the recovery will be much slower. This leads us to believe that the growth is probably going to be closer to a minus 10 or minus 11 and up a 0.4 cost is minus 11 contraction year-on-year. We will continue to monitor it as the data comes out. We are only now seeing the first data from April and May for the economy.
Severe manufacturing contractions.
Manufacturing has contracted by 44%, which is quite severe, possibly the most severe contractions. In a global sense when comparing relative peers only. India is the only other economy that saw a bigger contraction. We need to be realistic around growth for this reason.
The reasons why south Africa is in a bad state relative to other countries?
It’s worse in the world, worse than many of the more developed economies, but it might be too early to say it is one of the worst in the world without all the data. Our lockdown was quite severe compared to other countries. We tried to track it and it is all relative. South Africa has already been struggling with growth. That is the reason why analysts think that growth will be closer to a 10 or 11 contraction this year. The private sector will struggle more than usual. It is to a large extent with a government deficit of 15% which we think will happen in line with treasury’s thinking. The government is effectively crowding out the private sector this year and leaving no room for it to grow. Whilst this might occur in other countries, it is not as severe as it is in South Africa.
Looking at the downside risks and the upside risks.
With so many uncertainties it can be difficult to predict, the forecast error is huge. People who deal with these things know that the distribution around the point forecast in this environment is wide. On balance it is believed that the rescue is still that we get slightly weaker growth. Largely because we are seeing a slower opening up of the economy. Many businesses risk falling out of the supply chain and may not be able to come back at all. The ripple effect of this is devastating to the unemployment rate. In any downturn, unemployment is the reason SA tends to take rather long to recover.
Ultimately the upside risk would be a vaccine. The world would be able to open up substantially faster than everything else. That would be a positive for both SA and global growth. It would be a positive for asset prices including the rand. Unfortunately we cannot forecast around those things which is why we go with our best case of 10.
Shape of the economy.
For the 2020/2021 environment the outlook is most likely to be V shaped and will continue possibly into 2022. South Africa is going to continue to struggle to get above potential growth in a five-year view. Potential growth according to SARB is quite low, below 2%, which is too low.
Does a stronger Chinese economy result in a stronger South African economy?
South Africa has a natural link with China through net exports. 20 of our exports go straight to China most of it is commodities and raw materials. We also import, about 18 of our imports come from China. Mostly manufactured goods. Now if China rebounds it’s obviously net positive for South Africa.
The bottom line is that this year is going to be quite bad all around with a 10 to 11 contraction in GDP and a slow recovery post that, as the economy starts easing restrictions.
A look at currency
The currency gets stronger even if it’s a weak economy in South Africa. It is about the rand-dollar and not only the rand. Ultimately there are two sides to the coin, South Africa is going to contract but other countries are also contracting. Other countries fiscal position is deteriorating, which must be kept in mind. Looking at SA is comforting, if the rand depreciates in conjunction with other EM currencies and that is something that will most likely blow over.
It is a global story, and we have to look at the rand from all angles. One of the good things to compare the rand to is oil. Oil is a good indicator of what is happening in the global environment and the dollar. What it told us in April is that the rand is extremely undervalued. Take the rand relative to in terms of peaks and what happened in previous scenarios such as 1996, 1998, 2001 and 2008. The rand blows and we think it is the end of the world but when we analyse the rand relative to some trend you realise that the rand actually peaks at similar levels relative to this long-term depreciating trend.
One thing that is different is that SA’s fiscal position is substantially worse than previously. Our analysis doesn’t say that the rand won’t bounce back to a R15 handle. What it does, is prohibit the rand to shoot to a R12 against the dollar. In previous cycles we see that when you get these extreme events the rand overshoots substantially and comes back around and undershoots. In broad numbers, in 2008, we started depreciating from R8 against the dollar all the way to R13 and then all the way back to R6.50. We started the year at R14.50 and saw the rand go all the way to R19.50. It is a global story. It is an under-appreciation of EM currencies and a substantial negativity towards SA specifically which we think is to a large degree priced.
What should the SARB do?
We have a firm belief that inflation will only get back to 4,5% in Q2 of 2021 which is broadly the same projection as SARB. It is unlikely to spike substantially high. The only thing that we can actually see spiking substantially higher at this point, in Q4 of this year or Q1 of next year, would be food for example. For food prices to spike substantially we would need a drought, and possibly that might not even push prices up that high.
From a SARB perspective we view it as low inflation. It is rising towards the midpoint of the target. They are well aware of that but thinking in terms of what their loss function is, they back to 4,5% in 12 months. If they cut interest too much perhaps currency will depreciate. SARB doesn’t need to worry about currency at this point. Even if the currency trades at 20 to the dollar it will not push up inflation well above the midpoint of the target. Secondly the exchange rate passed through into inflation. Import prices into inflation are very low. We would be surprised if it is higher that 5% at this point because typically in downturn it is very low. The SARB do not target the rand but SA needs a 24-month view as a weaker currency rather than a stronger currency to help export and curtail imports.
The velocity of money within the economy is very low and that is what happens when the economy contracts by 15%. SARB has very little to lose if they cut the interest rate. We anticipated another 50 base point cut this year and 25 points next year. They will be conservative compared to what they were during the last MPC meeting. This is due to the forecast error which is still uncertain but it is most likely that they won’t make a policy mistake. The bias is that they cut more as opposed to hiking. If there is a hike it would be very low as long as the US remains zero bound.
The opinions expressed in this article are solely those of the analysts and do not reflect Nedbank’s views or policies.