By Dave Mohr, Chief Investment Strategist, Old Mutual Wealth.
South Africa’s economy contracted in the first quarter by -0.6%. The protracted strike in the platinum sector shoulders a large part of the blame, and even if the strike ends soon, it could still take up to three months for the platinum mines to get return to full operations. Manufacturing also contracted, and while other sectors grew positively in the first quarter, they displaying a weakening trend (with the exception of construction).
Worryingly, data from the second quarter so far has not been much better. New vehicle sales contracted 9.2% year-on-year in May, the manufacturing purchasing managers’ index fell to 44.3 in May, household credit grew by only 4.5% in April and the trade deficit ballooned.
Gross domestic expenditure, a measure of economic activity that excludes imports and exports (in other words only covers household consumption, government spending and business investment), contracted on a quarterly basis in the last two quarters of 2013, and could well have contracted in the first quarter of 2014 (the data will be available later in the month.)
This raises the question: is South Africa headed for a recession?
What is a recession?
A recession is often defined in the media as follows: an economy is in recession if real gross domestic product (GDP) contracts for two consecutive quarters. However this definition can hide important underlying trends in the economy.
Another way to identify a recession is to consider a number of data series to pinpoint, to the closest month, the peaks and troughs of the business cycle. In the US, the Business Cycle Dating Committee of the National Bureau of Economic Research has the task of determining the beginnings and ends of recessions in that country. It defines a recession as follows (emphasis added):
“A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. Because a recession is a broad contraction of the economy, not confined to one sector, the committee emphasizes economy-wide measures of economic activity.”
What causes a recession?
Historically, there are a number of different factors that caused the economy to contract, most notably:
- A global recession
As we saw in 2008/09, a global recession leads to a local recession. Our small, open economy tracks the global cycle, albeit with a lag of a few quarters. Fortunately, it appears that global economic growth is picking up, led by the United States. The Eurozone is finally exiting its double-dip recession, while Japan’s authorities are experimenting with unusual policies to stimulate growth. China’s economy is expected to continue growing around 7% p.a. over the medium-term, but a sharper slowdown is a big risk to South Africa. A growing global economy should keep us out of recession.
- Rising inflation leads to an interest rate shock
If inflation accelerates and is expected to be persistently above the Reserve Bank’s target, it will hike rates. This is the ‘classic’ cause of a recession – central banks trying to rein in an over-heating economy, and we saw that as well in 2008. Currently, the weak state of consumption spending means it won’t take too many hikes to tip us into recession. However, the weak state of the economy also limits upward pressure on prices.
The biggest risk to the economy at the moment would be a rapid rise in inflation due to a further sharp depreciation of the currency, forcing the Reserve Bank to hike rates repeatedly.
- Credit bubble bursts
Typically associated with a booming property market, runaway credit growth almost always ends in tears. At some point, marginal borrowers cannot make interest payments, setting off a cascade of fire-sales of properties. Property prices fall and bad loans rise at banks, who then contract lending even to otherwise creditworthy customers whose business go bust without access to funding. This condition was present in 2008, more so in the US and Europe than in South Africa.
The recent unravelling of the unsecured lending boom has had an impact on areas like furniture sales, but was generally contained to one section of the consumer market, and not experienced economy-wide.
- Commodity price shock
In 2008, an oil price spike helped tip the global economy into recession. This also happened in the 1970s. A rapid fall in commodity prices could also tip the local economy into recession, as was the case in the early 1980s when the gold price collapsed. South Africa earns about half its export revenues from commodities. Of our four major export commodities – platinum, gold, iron ore and coal – the latter two have experienced large price declines in 2014.
- Fiscal contraction
If the government is forced to reduce spending or hike taxes in an otherwise weak economy (i.e. fiscal policy is pro-cyclical), it could tip the economy into recession. This was demonstrated across the Eurozone recently. Ideally, a government wants to have ‘fiscal space’ to stimulate the economy when the private sector is weak, which was the case across the world and in South Africa post the 2008/9 crisis.
However, the fiscal space is now largely closed in SA. Interest repayments are already the fastest growing item in our national budget, and the government is committed to closing the budget deficit. The risk here is negative feedback where a weak economy reduces government’s tax intake, forcing it to increase tax rates, which could tip the economy into recession.
- Capital flows ‘sudden stop’
South Africa’s large and persistent current account deficits mean we rely on foreign capital to fund economic activity. If this capital flees, the Rand will fall rapidly, and the Reserve Bank will hike rates. We got a taste of this in January and remain at risk of global investor sentiment towards us and emerging markets in general. Even if the Reserve Bank does not hike short-term rates, long-term bond yields will rise, increasing borrowing costs. If South Africa’s sovereign rating falls by two notches, we would no longer be considered ‘investment grade’ and this could trigger outflows.
- ‘Supply-side’ shock
The protracted strike in the local platinum mining sector, the harsh winter weather in the US in the first quarter, and the military coup in Thailand are all examples of recent extreme events that can cause the economy to contract for a quarter. But it is unusual for such events by themselves to cause a recession. They would have to be very severe or long-lasting (like Syria’s civil war) to cause an economy-wide recession. Often, the economy bounces back quickly after a supply-side shock, followed by a phase of catch-up growth. One would expect platinum production to bounce back a few months after the strike ends. The other supply –side risk for the local economy would be electricity blackouts.
No recession yet, but risks loom large
There are thus several risks to the downside for the South African economy. Perhaps most worrying is that we have very little to buffer us against a shock. The Reserve Bank has very little scope to cut rates further, and has in fact indicated that we are in a hiking cycle.
Consumers generally have little savings to run down, and given high existing debt levels are unlikely to not react to lower interest rates to increase borrowing. They certainly haven’t used low interest rates over the past six years to leverage up. The consumer durable cycle – purchases of new vehicles, furniture and appliances – appears to have already rolled over (even before interest rates have risen drastically).
In the current climate, monetary policy is thus constrained. As discussed above, there is also little scope for fiscal policy to stimulate the economy due to the need to close the government’s budget deficit or face ratings downgrades and spiralling borrowing costs. Recent tax revenue numbers have been surprisingly buoyant, but if this trend turns, the Treasury could be forced to increase tax rates.
That leaves the Rand as the shock absorber of last resort. Fortunately much of the adjustment in the exchange rate is probably behind us. The Rand has weakened by 60% since late 2011, so while it might weaken somewhat further, it is unlikely to weaken significantly more given that it is generally considered to be undervalued. A weak Rand provides an immediate boost to the revenues of firms with existing export contracts. It also makes imports more expensive and exports cheaper, cushioning the local economy, especially if the global economy is improving. However, this process takes time, and is not yet fully underway.